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Inflation could spark further stimulus, economists warn

The Bank of England faces the challenges of higher inflation and lower consumer confidence due to the uncertainty surrounding Brexit.

Inflation could spark further stimulus, economists warn

The UK could be headed for further stimulus if inflation brings consumer spending to a halt, economists have warned.

Unlike the US, which is on course for further interest rate rises this year, commentators suggest the UK is on a different path.

It is ‘crunch time in the UK’, according to JP Morgan’s chief strategist Stephanie Flanders (pictured below), who highlights the impact of higher inflation due to the weak pound. This happened as a result of the European referendum and fears of a ‘hard’ Brexit, which would see the UK leave the single market.

Rising inflation could cause consumer spending to ease, as households feel the pinch, and make businesses reluctant to invest.

‘We will feel the consumer effects of a weak pound in higher energy prices and the cost of other daily goods,’ said Flanders.

‘If this causes consumption to ease off, possibly in the summer, as real wages are hit by higher inflation then we could have a problem with the economy. The normal thing that will fill the gap is investment in business and exports but that will be more in question, as we question all the trading relationships the UK has.’

This environment will create challenges for the Bank of England.

‘Far from increasing rates, it may be thinking about how to stimulate the economy if companies are holding back investment and we see consumption – which has been such a driver of recovery – ease off,’ she explained.

ING senior economist James Knightley agrees that businesses are likely to ‘sit on their hands’ rather than looking to invest and hire new workers once Article 50 is triggered.

‘Consequently, while the Bank is neutral on the outlook for monetary policy, we still feel that further stimulus is more likely than interest rate hikes over the next 18 months,’ he said.

Although inflation could overshoot the Bank’s 2% target this year, Emiel van den Helligenberg, head of asset allocation and Legal & General Investment Management, expects the central bank will still not look to raise interest rates.

‘The Bank will also want to keep its powder dry, so we don’t expect any interest rate cuts in 2017,’ he added.

Investment view

On a positive note, the uncertain political and economic outlook in the UK has not affected the attractiveness of some FTSE 100 stocks. These stocks have so far benefited from the weak pound, as much of their earnings come from overseas.

Although there may not be as much upside as last year, Flanders said the FTSE 100 still looks attractive compared to other geographies and markets. For example, a number of UK large caps have pricing power, which means they will be able to cope better with the effects of rising inflation.

Flanders said the outlook for both bonds and equities has already started to change - in line with a broader shift away from monetary policy towards fiscal stimulus. Monetary policy has determined interest rate decisions since the financial crisis hit in 2008 and focuses on the size and rate of growth of money supply, while fiscal policy relates to government spending and tax rates.

In Flander’s view, monetary policy is now ‘taking a back seat’ – a shift that is likely to have the biggest impact on bonds.

Less central bank interference will mean that government bond yields will not be pushed lower, said Flanders. Bond yields move in the opposite direction to prices, so yields rise when bond prices fall.

‘We are seeing the end of a long march down for bond yields,’ she added.

While investors may have made gains on long-dated gilts in recent years, this will be less likely in 2017.

‘It’s not because of higher inflation, or anything Trump may do, but because there is a change in attitudes of central banks. There is nothing in it for them any more to push yields down even further,’ she said.

Flanders also warns investors against assuming that index-linked gilts represent a good investment in order to counter the impact of inflation on portfolios.

‘You are only protected from an increase in inflation expectations holding index-linked gilts if real rates are falling - and if there is an increase in real rates,’ she said.

‘If we have a rise in real interest rates and we are not seeing a change in inflation expectations then you are not protected, and you will actually be worse off.’

This is because the so-called ‘break-even’ inflation expectations that are built into index-linked gilt prices currently look quite high. Flanders suggests the US inflation-linked Treasuries, known as ‘Tips’ may offer better opportunities. The break-even inflation rate is the difference between the rate of a normal bond and an inflation-liked bond with the same maturity.

6 comments so far. Why not have your say?


Jan 13, 2017 at 13:10

Further stimulus is more likely to lead to a further collapse in sterling and accentuate rather than attenuate the problems caused by inflation and uncertainty..

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William Bishop

Jan 13, 2017 at 13:16

To anyone with a longer perspective of history, the idea of responding to increased inflation with an interest rate cut may seem just a trifle peculiar.

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mark antrobus

Jan 13, 2017 at 14:45

The UK has a substantial trade deficit of about £120 billion p.a. This means that we as a country are living beyond our means and getting into increasing debt with foreigners. Therefore the fall in the £ over the last 14 months is exactly what is needed to make the UK more competitive, to stimulate demand by increasing exports and reducing imports, and REDUCE the need for ultra low interest rates which are leading to rising consumer unsustainable indebtedness. To put it another way the UK economy needs to be re-balanced from consumer spending towards exports and import substitution, What is desperately needed is RISES in interest rates but the £ kept low, or even pushed lower by Bank of England intervention.

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Law Man

Jan 13, 2017 at 16:57

Interesting previous comments. Could we have "stagflation": higher money inflation, but low growth - in which case (I guess) the outlook for the UK is poor. Over the last 9 months I have sold some of my UK equities and bought overseas (US and Asia).

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Alan Tonks

Jan 13, 2017 at 22:40

Michelle on 11th of January you wrote about investment officer Gareth Lewis giving his opinion about quantitative easing etc.

Only two days later the opposite is said about quantitative easing etc. Why, it’s easily answered because it is manipulated by the Government and banks for gain.

Therefore, they are non-stories because if we were living in the real world which we don’t these things would happen:

House prices would have collapsed long ago.

Many people would have had their homes repossessed.

Interest rates would be at a sensible level.

Banks would want people’s money rather than being supported by the Government.

Savers would have a decent interest on their savings.

The spendthrift’s brigade wouldn’t be helped out by the nanny state.

We would have a Governor of the Bank of England, who wasn’t a manipulating puppet for the Government.

Yes, and I could go on and on. but we do not live in the real world so the manipulators go forth and they multiply.

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James Pods

Jan 13, 2017 at 23:01

Alan Tonks, yes

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The Accumulator: FTSE see-saws on trade war fears

by Michelle McGagh on Jun 22, 2018 at 14:57

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