King wrong on inflation, managers warn

Several fund managers have warned the Bank of England is underestimating inflation in the UK, and they expect it to be higher for longer than predicted.

Inflation has been above the 2% CPI target for well over a year and recently hit 4%, causing the Bank of England to come under pressure to raise interest rates from a historic low of 0.5%, despite weak economic growth in the UK.

Last week the MPC voted to keep rates on hold again, two years after cutting it to 0.5%, although many managers anticipate a 0.25% hike by May.

King has warned inflation may well hit 5% and signalled there will be rate rises later in the year, but believes inflation will begin to fall back after that.

Although some managers agree with this view, several said a higher interest rate will have little effect on inflation, which is likely to be a concern for many years to come.

Bond managers OMAM's Christine Johnson and Rathbone's Bryn Jones believe inflation will be ‘stickier' and suggested the figures could be misleading.

Johnson, manager of the £33m Dynamic Bond fund, says inflation is a "longer term issue than is generally being viewed" because, as well is higher VAT, rising commodity prices and growing demand in emerging markets, domestic growth in the UK is also a factor.

"The expectation is inflation will be higher and stickier than perhaps the MPC is modelling at the moment. Also, domestic growth is going to be stronger this year, so you can expect the domestic level of inflation to start to pick up.

"This points to a world where you have to tolerate a higher level of inflation, because the ability to raise monetary policy to combat that is extremely limited."

Jones, manager of £55m Rathbones Ethical Bond fund, expressed his annoyance in a recent Conjecture debate. He said: "This temporary inflation thing drives me nuts.

"I think there is probably less spare capacity than we realise. When you go through recessions, spare capacity gets completely wiped out, we know that."

Last week he added: "We think King has underestimated inflation. Everyone talks about spare capacity in the economy, but a recession wipes that out.

"External forces are also more of an issue these days and sterling is weak so that has an impact, especially as many companies are international in nature.

"The other big argument is wage inflation. London is insulated from a lot of issues in the UK so if you have higher external forces and the country's major city is performing well, you will get feedback from that which will ultimately lead to wage inflation."

Richard Buxton, head of UK equities at Schroders, also struggles to support King, saying he has confused the issue of inflation.

"King has muddied the waters on inflation. I thought he had been quite sensible until a few weeks ago when he said although we have an inflation problem, he does not want to take any chances with the recovery, and inflation is a short-term blip, which he has been saying for the last three years. Now he says inflation will fall away as long as interest rates move up, then 24 hours later he said he did not mean that, and the markets were overreacting.

"He is an academic, and he does not always have his finger on the pulse - he thought Lehman Brothers was just a US problem."

Buxton adds he does not think we will see any interest rate rises this year as the MPC will realise the UK needs to "sweat" through inflation.

In contrast both M&G's Ben Lord and BlackRock's Richard Plackett sit in King's camp.

Plackett, who runs the £1.3bn UK Special Situations fund, said there is enough surplus labour in the economy to keep inflation under control.

"There is a significant surplus of labour capacity in most of the Western economies, so that brings into question the ability of workers to demand wage rises, which is how an inflationary cycle really gets going," he says.

Lord, who runs the £77m UK Inflation Linked Corporate Bond fund, described the effect of the rising oil price and increase in VAT as one-off factors and says CPI will fall in the medium term. In the meantime, he urges investors to add inflation-linked bonds to their portfolios as a form of protection.

Bill Dinning, head of investment strategy and economics at Aegon, also says the Bank of England's credibility has come into question.

"I think the Bank of England will be forced into raising interest rates by May just to say that they are aware of the inflation problem. I am not sure if this is good policy."

He forecasts inflation will remain above target until the end of 2012, having previously expected it to fall.

"If you asked me 18 months ago I would have said now. The issue is the persistence of the inflation."

Neptune's Robin Geffen also believes wage rises in the UK will stay low, pointing to the fact average wage rates have fallen below CPI since the autumn of 2009 meaning 10-year gilts investors are losing money.