‘Transitory’ inflation soars to 10-year high, with more pain to come

Inflation hit 2 per cent — the Bank of England’s target — in July this year, since when it has continued to rise, reaching 3.2 per cent in August. The BoE forecasted that it would hit 4 per cent by the year’s end, yet the true figure has comfortably exceeded this expectation.

Economists had told Reuters that inflation should hit 4.7 per cent in November, with the BoE predicting it would not hit 5 per cent until spring 2022, before dropping back to 2 per cent in late 2023. This latter prediction is now in doubt.

The phenomenon is not localised. In the US, inflation exceeded the most pessimistic forecasts, hitting a 40-year high of 6.8 per cent, while in the eurozone the figure reached 4.9 per cent.

Schemes that use inflation-sensitive assets as part of their growth strategies might find better value in Europe or the US; while inflation is high in these markets too, valuations are not quite as daunting as those found in the UK

Nigel Sillis, Cardano

The news has led many economists critical of central banks’ monetary policy to argue that the scaling back of quantitative easing is long overdue, with independent economist Julian Jessop telling the Guardian that the recession which once justified QE and low interest rates is long since over, leaving central banks “well behind the curve”.

Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown, said: “Faced with such a high inflation reading, and with forecasts that the only way is up, the BoE would ordinarily be expected to call time on the cheap money party and raise interest rates.

“But with the recovery far from being in full swing and the Omicron variant an unruly guest set to knock back confidence further for many sectors, policymakers may be hot and bothered but are likely to stay in wait-and-see mode tomorrow.

“What is pretty certain is that even if ultra-low rates stay put right now, with prices running so hot, there won’t be an extended lock-in with expectations that February is likely to see rates lift,” she added.

Particular attention will be paid to the response of the US Federal Reserve, Streeter continued, which “seems much more inclined to bring the cheap money binge to an end”. 

“Focus will shift to the Fed’s decision on monetary policy later, and with fresh indications that inflation is sizzling hot with producer prices reaching a record annual increase of 9.6 per cent in November, there are expectations that last orders will be called on its mass bond-buying programme much sooner, and that an interest rate rise could be brought forward next year.”

She added that with growth “much more buoyant” in the US than it is in the UK, “withdrawing support doesn’t appear to be quite so much of a dilemma”.

Pension problems

As Pensions Expert reported in September, the implications for schemes depend largely on the extent to which they are hedged against inflation.

Chris Arcari, senior investment research consultant at Hymans Robertson, said at the time: “Most schemes provide inflation indexation (linked to the retail price index or consumer price index) on benefits accrued after April 5 1997, while around 50 per cent provide inflation indexation on benefits accrued before April 6 1997.  

“However, most schemes will be less than 100 per cent hedged on inflation — therefore, higher realised and implied inflation will result in a greater increase in liabilities relative to assets, and so generally an increase in deficits.”

He continued: “Sustained high inflation could be a real challenge for many pension schemes. Trustees should consider not only how robust their investment portfolio would be in a more inflationary environment, but what this would mean for the sponsor covenant and their ability to support higher costs.”

The Pension Protection Fund cited inflation as a significant risk in its annual report, published in October.

PPF chief executive Oliver Morley told the Pensions Expert podcast that the PPF would have to “pay particular attention” to inflation, adding that, “just as it was quite difficult to predict what would happen with furlough and things like that, in terms of the impact on our universe, I think it is true that inflation could add a level of volatility that makes it quite difficult to tell exactly what will happen over the coming year”.

Commenting on November’s figures, Nigel Sillis, client portfolio manager at Cardano, said: “Current levels of UK inflation are not unprecedented. There were higher peaks in CPI, and comparable peaks in RPI, recorded in both 2008 and 2011.

“More notable right now is the deterioration in market-based measures of future inflation, as these point to an overshoot of the BoE’s inflation target for a prolonged period into the future. Pension funds are paying more to hedge their inflation risks today than they have been at any time in the past 10 years.

“It remains to be seen how ‘temporary’ the present raft of inflation-stoking supply disruptions are, how current trends may be aggravated by Omicron and, beyond that, we have not yet seen the full effects of higher energy prices upon consumer prices more generally,” he continued. 

“There are still upside risks. Amid uncertainty, pension funds should aim to fully hedge. However, schemes that use inflation-sensitive assets as part of their growth strategies might find better value in Europe or the US; while inflation is high in these markets too, valuations are not quite as daunting as those found in the UK.”

State pension implications

LCP partner Sir Steve Webb suggested that the deteriorating economic picture could cause a rethink of the “modest” state pension increase decided earlier this year.

The state pension is due to rise 3.1 per cent in April next year, in line with CPI inflation in the year to September 2021. But inflation having risen to 5.1 per cent, with further rises expected in the near future, could lead to a “significant squeeze” on the living standards of more than 12m pensioners, with the poorest 2m particularly affected.

Certain company or private pensions may be harder hit still as not all schemes are equivalently hedged against inflation, while anyone who bought a “level” annuity will see no annual increase at all, Webb warned.

Additionally, inflation will hit the savings pensioners hold in individual savings accounts and other investment vehicles, which have interests close to zero. The real value of these savings is likely to fall by at least 5 per cent.

“The government has shown that it can change universal credit rates at short notice when it wants to, and it will now come under pressure to rethink the modest state pension increase it had planned for April 2022,” Webb said.