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April saw the rise of inflation, but is it here to stay? We look to what has caused this rise, with comment from the experts.

For almost two years, as the UK struggled with the financial crisis, deflation was the big worry for the economy. But inflation is back, in spades. What is driving it and where could it go from here?

April saw inflation reach a peak for recent times. The Consumer Prices Index (CPI) hit a 17 month high of 3.7%, with the Retail Prices Index (RPI) which includes housing costs – a common reference point for wage negotiations – being the highest for 19 years at 5.3%.

That said, April may have marked the peak for the time being, with both indices falling off slightly in May. However, inflation has some way to fall before returning to the Bank of England’s CPI target of 2%. The Bank’s governor, Mervyn King, said last month that the rate would be back below the target by the end of the year.

How do current rates compare with our neighbours? Not well. The provisional April inflation figure for the European Union as a whole was 2%, nearly half the UK rate. Germany actually dipped into deflation in May, with prices falling by 0.1% compared with May 2009. There are countries in wider Europe with higher inflation rates, but the list is not comforting – Greece, Hungary, Russia and Turkey.

Why does the UK seem to be feeling more inflationary pressure than its peers? This can be partly, but not wholly, explained by the effect of a weakening pound which has made all imports more expensive and magnified dollar denominated oil prices. Higher energy prices feed, via transport and other inputs, into higher food costs, as they do into most areas of economic life.

There has been the inflationary effect of VAT’s return to a 17.5% rate from January. The April figures reflected the annual increase in excise duty on alcohol and tobacco. One feature of any recovery from recession, however slight, is that manufacturers seize the opportunity to raise prices or discontinue any discounts they may have been offering.

House price inflation has returned to double digits, according to the Department for Communities and Local Government. It said that prices in April were 10.1% higher than a year earlier, the highest rate since October 2007. The only part of the UK where house prices are still falling is Northern Ireland.

There is no absolute consensus on where inflation is heading. Oil prices have fallen and the pound has strengthened, which should have a dampening effect. So too will the public spending cuts now being unveiled by the government. Some think the combined effects will be enough to depress both CPI and RPI close to zero by year’s end.

Others see them more or less where they are now, predicting that sterling will fall while oil and commodity prices will rise. The inflationary effects of quantitative easing have yet to be fully felt and could help to counterbalance any downward pressures.

There are also those who agree with Mervyn King that the CPI will head back to 2%, as long as the pound remains stable, though inflation could be building up again in two years’ time.

Rising inflation is traditionally the enemy of bond markets; driving up interest rates and causing bond prices to fall. However, for now, market fundamentals remain credit friendly, according to John Anderson, Gartmore’s Head of Credit.

“Corporate earnings have been strong and, despite being stubbornly above target inflation, the new coalition government has chosen to focus on tightening fiscal policy, dampening the need for any immediate hike in interest rates,” John says. “However, we remain vigilant as exogenous shocks, namely further sovereign risks, can still adversely impact credit markets.”

Click for more information on John Anderson’s Gartmore Corporate Bond Fund.

The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance is not a guide to future performance. Please ensure investors read the Simplified Prospectus before investing. The views expressed are Gartmore's views and must not be taken as an offer to buy or sell units or shares in the markets mentioned. These views are provided for information purposes only. The views expressed are as at 24 June 2010 and are subject to change.

• This entry was posted on: Wednesday, 30 June 2010 09:25 BST
• Filed under: Current, News
• Tags: Gartmore Corporate Bond Fund, Inflation, John Anderson, News
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