5 July 2008: Barclays Wealth research says policy makers cannot fix inflation problems quickly

The July edition of the Barclays Wealth Signpost Quarterly Investment Strategy Report argues that the problems posed by the recent upturn in inflation are serious, and that central banks will find it difficult to deal with them. Oil prices and inflation are unlikely to fall back sharply, and there are potentially severe problems stemming from wage/price spirals in some of the major developing economies. The outlook looks increasingly gloomy for 2009, and Barclays Wealth has reduced its overall equities overweight. But Barclays Wealth still expects growth in the major developed economies both this year and next.

Michael Dicks, Head of Research and Investment Strategy, Barclays Wealth, said: "When the credit crunch erupted last year, the world’s major central banks were quick to react. However, with the reappearance of a beast from the past – inflation – their options are now much more limited. There will be no quick fix.”

The inflation and growth outlook in brief

An old beast from the past – inflation – is now back with a vengeance.

Central banks have already responded by threatening tighter monetary policy, and interest rate cuts are clearly off the agenda for now – with the ECB actually about to nudge rates up.

The economic mood has therefore darkened, with higher interest rates threatening to undermine a hesitant recovery in growth.  Accordingly, equity markets have fallen back and many believe that there is worse to come.

The increase in inflation owes much to high commodity prices.  Rises in commodity prices hit the world economy at a vulnerable time, with evidence that the global economy was running at close to non-inflationary capacity at the end of last year. 

There is some limited evidence that slower growth may now ease inflationary pressures in the developed economies, but any complacency would be dangerous. Aside from higher commodity prices, wage/price spirals in several developing countries give cause for concern.
The effects of these wage/price spirals are being exacerbated by what could be described as ‘mercantilism’ in some developing economies, i.e. keeping their exchange rates low in order to make their economies competitive, which makes their policymakers disinclined to deal with the problems underlying them.

This ‘mercantilism’ is manifest in a reluctance by some developing economies to raise interest rates sufficiently, or to hold down public subsidies on foodstuffs and energy.

Failure to act here has kept demand above supply, boosting inflation and wage demands.  The longer this problem is ignored, the bigger the ultimate cost of getting things back on an even keel.

Were these wage/price spirals spread to developed countries, we would indeed be back to the stagflation of the 1970s. However, we do not think that this will happen.

We not believe that higher oil prices will fall back sharply, with supply/demand pressures as well as speculation keeping prices high. We calculate that high oil prices will have a larger impact on the world economy than many economists currently predict. We also do not expect inflation to fall back sharply, with it only peaking towards the end of this year.

Nonetheless, we think that the financial markets have overreacted to central banks’ recent focus on inflation: in other words, we think that interest rates are unlikely to rise by as much as markets have priced in. The ECB may baulk at raising rates further after the July rise, with the Bank of England possibly considering rate reductions again at the end of this year.  The Fed is expected to keep interest rates on hold until mid-2009.

In response to the deteriorating economic environment, we have trimmed our global GDP growth forecast to just under 3% in 2009. This would be the weakest outturn since 2003, but not a bad result by historical standards. 

We have also trimmed back our overall equities overweight to 4 percentage points. Better US consumer spending news should allow US equities to regain some ground soon. We remain short on fixed income. We are however, less positive on the rest of the world, and we have decided to cut back our Europe ex-UK equities overweight and go neutral on the UK itself.  Caution is advised in reacting to any future sunshine: with US growth likely to remain anaemic, any future US equities pick up would not look to us like the beginnings of a bull market.

For further information contact:

Barclays Wealth
Nicola Hankey, Head of PR      
020 7114 9813 / 07775 548418
nicola.hankey@barclayswealth.com

Jignasa Patel, PR Manager  
020 7114 9813
jignasa.patel@barclayswealth.com