The UK remains mired in stagflation: here’s what to do
John Stepek Aug 09, 2012
Just in case anyone was feeling too cheerful amid Britain’s fantastic Olympic performance, Sir Meryvn King came along to rain on the parade yesterday.
In short, everything’s awful.
The UK economy won’t grow at all this year. Just a year ago, the Bank of England’s prediction was for 2% growth. The recovery has been somewhere between pitiful and non-existent.
And it’s not for want of trying on the Bank’s part. We’ve seen plenty of money-printing and interest rates can’t go much lower.
Still, at least Sir Mervyn has inflation beat. Doesn’t he?
The Bank of England’s real inflation target
There’s an upside to the weak economy, apparently. Inflation may return to the target level by the end of the year. Indeed, Sir Mervyn reckons there’s a danger that it will fall below the Bank’s forecasts.
That would be great. Part of the big problem for the UK has been that wage growth has been below inflation. In real terms, consumers are getting no interest on their savings, and their cost of living is rising. Meanwhile, they can’t get hold of as much credit as they used to.
So, given that Britain is a consumer-driven economy, it’s little wonder that we’re struggling.
There’s just one problem. Judging by history, the chances of this ‘below-target’ inflation materialising for long, if at all, are incredibly slim.
In fact, I’m amazed that people continue to treat the Bank of England’s inflation forecasts as credible predictions. The inflation forecasts do tell you something, but it’s not what the rate of inflation will be - it’s what the Bank wants you to think it will be.
Let me explain.
Lead indicators for Britain's economy
What is the Bank’s real goal here? Yes, its target rate for Consumer Price Index inflation is 2%. But that’s not what the Bank is really aiming for these days.
Britain is heavily indebted. That’s what is weighing down the balance sheets of banks, consumers and the government. Writing off the debt is one way to get rid of it, but it’s potentially very traumatic.
A less painful, but long and drawn out way of getting rid of the debt, is to inflate it away, while keeping interest rates low. Sticking to the 2% inflation target isn’t the way to go about that; you want inflation to be at least a little bit higher than that.
But you can’t admit this. Because if you acknowledge that you just want to inflate debt away, then people will start actually worrying about inflation. The rates people demand for lending money might start to rise to compensate for this future inflation, regardless of what you do with interest rates.
As you may have noticed, every time the inflation rate approaches the 5% mark in the UK, it starts to become a headline issue. So it’s a real tightrope.
That’s why another of the key jobs of any central bank is expectations management. Having a target that you can pretend you are trying to stick to is a useful way to avoid scaring the horses.
If I were Mervyn King, I’d keep saying I had inflation under control too. But I’d probably be aiming for an ideal level of between 3% and 5%, with an average of 4% keeping me happy.
With inflation below 2.5% right now, that might seem an overly cynical take on the Bank’s position. But as Simon Ward at Henderson Global Investors points out, “the governor’s self-congratulation about inflation performance and prospects… is premature.”
Why? “Much of the first-half decline reflects commodity price weakness that has since reversed, while core pressures – particularly in the services sector – remain stubborn.” Inflation, says Ward, is likely to stay above the 2% target and start rising again later next year.
Moreover, by talking down inflation, Mervyn leaves himself room for more money-printing in the near future. That usually means a weaker pound, which in turn leads to higher inflation.
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What this means for your money
The trouble is, while the Bank might be too optimistic on the inflation outlook, it’s probably got the awful growth outlook about right. And the 'Funding for Lending' scheme (FLS) is unlikely to help much.
Yes, it will lower the cost of funding for banks. But the chances of this being passed on to consumers in any meaningful way seems very low, as MoneyWeek regular James Ferguson pointed out when the scheme was launched. (If you’re not already a subscriber, you can get your first three issues free here.)
We’ve already seen the launch of several cheap fixed-rate mortgage deals for people with huge amounts of equity in their homes. But that’s not expanding lending, it’s just making borrowing that bit cheaper for people who didn’t really need it in the first place.
In other words, we can expect today’s environment of grinding stagflation – slow growth and rising prices – to continue into the future.
That in turn means that money will continue to be tight for consumers. The best you can do is make sure you have your cash savings sitting in the best-paying Individual Savings Account you can find.
As for your investments, it’s another good reason to hang on to the solid dividend-payers we’ve been favouring for a while. Big companies can cope with stagflationary conditions better than most, mainly because they are in a better position to set prices than other companies.
No doubt about it, it’s an increasingly crowded trade. And blue-chip dividend payers are not the only things we’d suggest putting in your portfolio: we like cheap European and Japanese stocks, and gold too. But having a core section of your portfolio that pays a decent income that you can reinvest in other opportunities as they arise still makes sense to us. For more on building an income portfolio, see my colleague Phil Oakley’s recent piece on the topic: Build an income portfolio that could set you up for life.
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