Is inflation back from the dead?

Recent signs of higher inflation in many advanced economies have prompted the question of whether inflation is coming back from the dead. The answer is most likely a qualified “no”. The shift to an era of low inflation does not mean that there cannot be periods when inflation is rising rather than falling, but current concerns about increasing inflationary pressures are exaggerated. How come?

Inflation is still pretty subdued. Core inflation in the OECD economies is averaging less than 2% and headline inflation around 2.5%. Given the huge increases in energy and commodity prices over the past year, the real surprise is that inflation has not risen further and faster. Even in the US, core inflation was a comparatively modest 2.3% in April, up from 2.1% in March. Indeed the expected slowdown in the housing market might have a double negative impact on US inflation: it will reduce it indirectly, by undermining demand, as well as directly via the rental components of the CPI.

Even if energy prices remain at their current highs, their impact on headline inflation will fade. For oil price inflation to be higher this year than in 2005, the price of Brent crude would have to average more than $90 per barrel over the remainder of the year.

Despite the stronger pace of world growth in recent years, there is still plenty of spare capacity in the world economy. Negative output gaps remain the norm among the G7 economies, particularly in Europe. What’s more, the increased integration of China and other developing economies may raise sustainable growth rates for a while longer.

However, this does suggest a new threat to the inflation outlook. The possibility of a lurch towards protectionism might reverse the downward pressure on inflation from globalisation.

Global Equities: Watch Bond Yields

Near-term downside for global equities will be limited if bond yields decline.

Global equities have corrected by 5% in the past three weeks, as investor risk aversion has risen. The drop in share prices followed a steady climb in bond yields. However, stocks got some support last week as global bond yields edged lower.

In the past three years, equities have struggled whenever bond yields have risen, but subsequently rebounded once bond yields rolled over. If worries about stagflation are misplaced, as many believe, bond yields should fall as global growth cools.

Bottom line: While the equity correction may have further to run, investors should focus on bond market behavior; a further decline in bond yields would help stabilise global stock markets.

The Fed’s Dilemma

The recent FOMC Minutes offered little to calm market jitters, suggesting that market volatility will persist in the near term.

The Fed’s dilemma was clearly evident in the May minutes. Some policymakers wish to pause for fear that higher rates could trigger excessive economic damage. Meanwhile, the FOMC reiterated its concerns about upside inflation risks, even though inflation expectations were still described as “contained”.

Financial markets will remain volatile until it is clear that growth has downshifted and that inflationary pressures have eased. The next set of inflation data will determine whether rates rise in June. Bottom line: Expect this scenario to unfold, but fears of stagflation could continue to rattle markets in the near term, especially with an untested Chairman at the helm.

Technically speaking…….

FTSE-100 (5706) turned in a decent performance on Wednesday thanks to a firm opening on Wall Street and a retreat in the oil price. Gains in the leading index were fairly broad-based as it climbed 72 points, recouping less than half of the previous day’s losses. The net result for the month of May, however, was less impressive - the FTSE shed 299 points to record its worst monthly performance since January 2003, although it is worth mentioning that it ended the month well above the May lows, and that could yet turn out to be decisive. At the moment there is still plenty of volatility and it is not yet clear whether this is the precursor to a rally or to further declines - while that remains the case it is probably best to be highly selective with equity investments.

And finally………

THIS DEPT OF TRANSPORT INITIATIVE HAS BEEN RE-LAUNCHED, MAY & JUNE 2006.

Information Release.

Due to the nature and quality of driving in England the Department of Transport has now devised a new scheme in order to clearly identify poor drivers and give other road users the opportunity to recognise them.

For this reason as from the middle of May 2006 those drivers  who are found to be driving badly

(this includes:
-overtaking in dangerous places;
-hovering within one inch of the car in front;
-stopping sharply;
-speeding in residential areas;
-pulling out without indication;
-performing U turns inappropriately in busy high streets;
-under taking on motorways and
-taking up more than one lane in multi lane roads),
will be issued with flags (white with a red cross) that will signifying their inability to drive properly.

These flags must be clipped to a door of the car and be visible to all other drivers and pedestrians.

Those drivers who have shown particularly poor driving skills will have to display a flag on each side of the car to indicate their greater lack of  skill and
danger to the general public.

Department of Transport.

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.