Today’s announcement that inflation ticked up 0.1 per cent in July year-on-year has come as a surprise to many investors following a recent rise in sterling and the continuation of low oil prices.
The Office for National Statistics said that stronger contributions from education, restaurants and hotels, and clothing and footwear – the latter caused by less aggressive discounting – were the reasons for the unexpected move.
The news follows an almost flat spell for the consumer prices index (CPI) over the last six months, with inflation creeping up to 0.1 per cent in May and falling again in June.
While there has indeed been a rise, there are concerns that it is minimal and remains shy of the official 2 per cent inflation target.
What will this surprise but small increase mean for UK investors and what indications could it hold for market behaviour in the near future?
A factor that will immediately spring to investors’ minds is the impact this will have on any bonds they are holding in their portfolio. Many investors have shunned the traditionally ‘safe’ fixed income assets in light of the impending rate hikes from both the Federal Reserve and the Bank of England.
Performance of sectors in 2015
Source: FE Analytics
Shaun Port, chief investment officer at Nutmeg, believes that recent economic news has balanced out to encourage more bond ownership, but he warns that higher base rates are inevitable over the next year.
“Borrowers need to consider the impact of this on future higher mortgage rates and savers need to consider the impact weaker bond prices (higher bond yields) will have on their investment portfolios,” he said.
To protect from the combination of higher inflation, wages and interest rates, Nutmeg has given an underweight to bonds and an overweight to UK equities in its clients’ portfolios. 
What is more difficult to protect against, however, is the influence inflation may have on central banks’ decisions to raise interest rates sooner than expected, which is likely to impact the economy and markets significantly.
Azad Zangana (pictured), senior European economist at Schroders, says the latest inflation figures show that lower prices for food and energy are masking signs of an increase in domestic inflation, which is being bolstered by a wage growth increase and greater purchasing power for UK households.
“Inflation based on the retail price index [RPI] also rose 1 per cent year-on-year, unchanged from the previous month,” he said.
“Overall, the latest inflation figures show signs of a healthy economy that is enjoying the dividends from lower global commodity prices. The Bank of England has started to question how long interest rates can remain at current record-low levels, but in our view, is unlikely to hike rates before CPI inflation returns to at least 1 per cent, which may not happen before the second quarter of 2016."
Ben Brettell, senior economist at Hargreaves Lansdown, believes the latest figures will in fact cause the Bank of England to raise rates sooner than people expect, because of the rise in core inflation and the underlying inflationary pressure that it suggests.
“The key figure in today’s inflation data was not the headline CPI rate, but the surprise jump in core inflation,” he explained.
“This figure, which strips out volatile components like food and energy, jumped sharply to 1.2 per cent, confounding expectations for it to remain flat at 0.8 per cent,” he explained.
He added that markets seem to agree, following a spike in sterling immediately after the figures were released which amounted to around a cent rise against the dollar and almost a cent rise against the euro.
Performance of dollar vs sterling over 1month
Source: FE Analytics
Adam Chester, head of economic research and market strategy at Lloyds Bank Commercial Banking, agrees that the most significant figure released this morning was the core inflation rate, despite CPI numbers defying expectations that inflation would return to negative territory.
“While the headline rate of inflation ticked up from 0.0 per cent to 0.1 per cent, the ‘core’ rate jumped higher than it has been for five months. The stronger-than expected outturn was largely due to stronger contributions from education, restaurants and hotels, and clothing and footwear – with the latter reflecting less aggressive summer discounting,” he explained.
“The surprise rise, especially in the core rate, has led to a knee-jerk spike higher in the pound, and reaffirmed market expectations that UK interest rates could rise in the first half of 2016. While the Bank of England is unlikely to read too much into one month’s data, the pickup in the core rate is a timely reminder that not all indicators of inflation are pointing south.”
In terms of the headline CPI, Brettell says this is mostly driven by oil price, which is of course out of the central banks’ control. Because of further falls recently he expects the rate of inflation to remain depressed well into next year, although this is a temporary factor and may not impact central banks’ decisions to raise rates.
“Today’s numbers will increase speculation over a rate rise later this year. Possible, but not probable is my view. It will take some time for more MPC [Monetary Policy Committee] members to be persuaded to vote for higher rates, and I still think early 2016 is more likely. Thereafter the path of rate rises is likely to be a slow incline, and it wouldn’t surprise me to see them stuck on 0.75 per cent for some time,” the economist predicted.
A report released today from Capital Economics concurs that the inflation results are unlikely to rush the MPC into increasing interest rates before the end of the year, as its research team expects inflation to remain below the 2 per cent inflation target both this year and next year.
It adds that the recent fall in oil price has not been fully reflected in prices yet and that gas suppliers are expected to slash their prices in the near future, following British Gas’s announcement that it will cut prices by 5 per cent.
“Inflation should pick up as the anniversary of the plunge in oil prices late last year is reached, but it still looks likely to remain well below the MPC’s 2 per cent target throughout next year,” the report stated.
“Pipeline price pressures remain very weak – July’s producer prices figures showed that output prices were 1.6 per cent lower than a year ago. In addition, long time lags between changes in import prices and shop prices mean that sterling’s recent rise will keep a lid on CPI inflation until the end of 2016.”
“With inflation muted and another wave of austerity set to hit the economy, we still think the MPC will hold off from raising interest rates until Q2 2016 and will increase bank rate to just 1 per cent by the end of next year.”
