Inflation “will be close to zero” by height of summer

Inflation will fall within touching distance of 0% in the next few months as the recent collapse in oil prices and a record one-off hit to UK economic activity send it tumbling, according to Sandra Holdsworth at Kames Capital.

The UK government and Bank of England policymakers are looking at a very severe contraction in the second quarter of 2020, with some predictions that it could be the largest economic decline ever documented. While there will be some recovery later this year and into 2021, the lost output will not return until at least 2023.

Against this backdrop, CPI inflation has fallen precipitously to 0.8% in April after a sharp dive from 1.8% in January prior to the crisis.

Holdsworth, Head of Rates at Kames, expects this to fall to virtually zero in the next few months.

“Inflation is falling fast for a variety of reasons, but chiefly because of the collapsing oil price, and over the summer months we expect inflation to fall close to 0%,” says Holdsworth.

Despite reports of big queues at reopening businesses, Holdsworth expects consumers will be slow to return to spending overall, while the oil price will not recover to highs seen at the start of the year because of lost economic output globally.

As such, she also expects core inflation to dip further. “Core inflation, which gives a measure of inflation outside of energy, will also be falling, and we expect it to fall towards 1% this year. That is something the Bank of England will be concerned about. Deflation is now a real worry.”

Holdsworth believes the inflation outlook will see the Bank of England press on and use all monetary tools at its disposal to hold back the spectre of deflation.

“There’s no reason to think the Bank of England won’t extend its QE program in the months to come,” she says.

“Mark Carney didn’t want to introduce negative interest rates, but the new governor seems much more open to the idea. Andrew Bailey has reopened the debate and removed that certainty that it wouldn’t happen in the UK, and the economy is so poor you wouldn’t rule it out right now.”

Despite the record issuance of debt to pay for the bailout of the UK economy as it responds to coronavirus, gilt yields have remained anchored near 0% (and below that at the lower end of the curve)

Holdsworth says this scenario will not change thanks to Bank of England purchases.

“Fortunately for the gilt market there is one big buyer out there in the Bank of England. It is buying government bonds at a pace that has never been seen before, and so despite the enormous ramp up in supply, gilt yields have actually been falling,” she says.

“This is partly in response to falling inflation and the crisis environment, but you have to wonder when this supply begins to affect the level of yields just by its sheer existence.

“After all, the Bank is now buying more debt than the government is issuing, and whether it can continue to do this while the supply is so high remains to be seen.”

Nonetheless, with QE very much in play, Holdsworth says support for both gilts and other assets remains firm.

“QE keeps risk-free rates very low and encourages holders of those risk-free assets to take risk elsewhere and either move down the list of credit quality in the fixed environment, or in corporate or high-yield bonds. It can also send investors out of the fixed income universe entirely to look for income in equities. That movement of capital gives a lot of support to markets.”