Investor/An insider's guide to the market: An important feature of the economic landscape over several years now is the persistence of low rates of inflation in all major economic blocs.
In Europe inflation has generally been close to the European Central Bank (ECB) target rate of just below 2 per cent. In America the Federal Reserve does not have a specific target-rate of inflation but its statements regularly emphasise controlling the general rate of inflation.
Inflation in the US has been a little higher than elsewhere but even so it has normally been below 3 per cent. The rate in Ireland has been close to the European average, although three to four years ago the economy endured a period of above average inflation.
One consequence of this prolonged period of low inflation is that yields on long-term government and corporate bonds have remained lower than most investors and analysts have been predicting since early 2004. By early 2004 it had become clear that the Fed had embarked on a policy of monetary tightening.
Historically, rising short-term interest rates have been accompanied by rising yields on government bonds. It was not surprising to find that most market experts were predicting a rise in bond yields at the beginning of 2004. As it turned out they were wrong-footed, with global bond yields actually declining in 2004. Once bitten, twice shy and at the start of 2005 analysts were generally a little more cautious regarding bond yield forecasts.
Nevertheless, the consensus view was that the Federal Reserve would continue to raise short-term interest rates and consequently it was felt that 2005 would indeed be the year of rising bond yields. So far at least it hasn't happened although recent data on inflation has led to some upward pressure on yields.
The substantial rise in energy prices in 2005 has not as yet fed through into the general price level. However, inflation data just released this week indicates that this may be about to change. In September, US producer prices jumped by 1.9 per cent which was the sharpest rise in 31 years. This was significantly higher than analysts' expectations of a 1.2 per cent rise. Energy was the biggest contributor to this rise although the core index rose by 0.3 per cent against analysts' predictions of 0.2 per cent .
In Europe, German production prices rose by 4.9 per cent in September compared with 12 months ago, which is the highest annual increase in four-and-a-half years. In the euro zone the annual rate of consumer price inflation spiked at 2.6 per cent in September, after a rise of 2.2 per cent in August. Economists had been expecting some acceleration in the inflation rate but only to 2.4 per cent. If this rate of inflation persists for more than a few months it would almost certainly lead to higher euro short-term interest rates.
This recent flow of inflation data does suggest that the next three to four months will be crucial for medium-term inflationary expectations. If higher inflation takes hold then it could feed through to higher wage demands, which in turn would create additional price pressures. In Investor's view this is a remote possibility due to the persistence of high unemployment rates in Europe, and the availability of low cost labour from eastern European entrants to the EU. In the US and the UK there is very little sign of growing wage demands. Moreover, the emergence of China and India, is increasing the global supply of goods and services at lower prices.
The three to six month picture could well be one of upward pressure on inflation that is sufficiently high to cause the ECB to raise its rate above 2 per cent . A rise to 2.5 per cent or 2.75 per cent within this timeframe is a possibility. However, in Investor's view longer-term deflationary forces will regain the upper hand. As a consequence it is difficult to see the ECB rate rising above 3per cent on a 12-18 month view.
