Many economists believe it may overshoot even this forecast by some margin, however.
The National Institute of Economic and Social Research forecast in early November that inflation will jump close to 4% by the summer of 2017 while HSBC expects inflation will hit 3.7% next year.
Aviva’s Dewey says a 20% devaluation of the currency could reasonably result in 4-6% higher inflation than could occur without that depreciation.
As a result of this increased tolerance for inflation, interest rates are unlikely to go up significantly any time soon.
Andrew Tunningley, head of UK strategic clients at Blackrock says: “Don’t expect UK rates to go up in any meaningful magnitude for many years.”
Andrew Pease, global head of investment strategy at Russell Investments, says it is plausible that the BoE could prove itself tolerant of inflation that is persistently above its 2% target for as long as five years.
The rates on longer-dated securities that underpin discount rates are of course more important to institutional investors, but, as M&G’s head of institutional portfolio management, David Lloyd, says: “The biggest single determinant of bond yields is the official rate.”
He goes on to say this presupposes that the market believes the central bank is either ahead of or on the curve. “Any notion the bond market gets that the authorities are behind the curve and markets will draw their own conclusions. We are not in that environment yet, though,” he says.
Rates have fallen at both ends of the curve over the last year. Yields on six-month and two-year gilts fell 28 and 37 basis points respectively between the start of January and the end of October 2016. Yields on 30-year gilts fell 78 basis points over the same period.
Managing cashflows in a backdrop of rising short-term inflation, and low short and long-term interest rates will become an increasingly critical issue for institutions in the coming years. And, if rates stay low for as long as five years, this problem will continue to plague institutions into the medium term.
THE WRONG KIND OF INFLATION?
The hope among many is that the current increase in inflation will prove to be a short-term issue. The inflationary pressure of the falling pound is expected to ease off after a few years and inflation should correct itself. A scenario based on lower growth resulting from Brexit would seem to support this argument.
Brexit will play a critical role in determining the path inflation walks and whether or not higher levels will be constrained to the short term. And even if they’re not, will that necessarily be a good thing for institutions?
As OMAM’s Lebleu says, the nature of the inflation will be key.
The “right” type is where inflation is no more than around 1% above target over the medium term and is driven by global and UK GDP growth surprising on the upside.
According to JLT’s Sheth: “This is not the current driver of higher inflation and inflation expectations, which are to do with sterling depreciation and, possibly, a reduction in the supply of workers. The worst scenario would be one of ailing growth and high inflation (the stagflationary scenario). Here, the Bank of England’s Monetary Policy Committee tools of the last several years – low interest rates and quantitative easing – would be less effective, if at all.”
Brexit will have a big impact on which kind of inflation the UK experiences. If the UK is able to maintain a viable trading relationship with the EU, weaker sterling should act as a tailwind for the exports and the wider economy. “If the UK is not able to maintain that relationship, it will almost inevitably end up in a recessionary environment,” says Aviva’s Dewey.
