Economics: Low inflation puts fire in the market

LAST WEEK'S surge in share prices looks paradoxical alongside the poor economic data. The stock market, of course, is so good at looking to the future that it has predicted five of the last two recoveries. But its behaviour this time is not due to its predictive powers. There has been little revision of the forecasts for profits. The explanation has more to do with the performance of rival investments, which in turn depends on the prospect of low inflation.

The stock market always likes falling interest rates, because they make holding cash less attractive. Savings seek out other homes. It is less well known that the market also likes low inflation: stable prices usually mean low interest rates, but they also make the fixed interest payments on government bonds more valuable in real terms. Cash has been flooding out of money market deposits and into higher-yielding securities with longer periods to maturity.

Government bonds - gilts - had another sparkling week, and are now up by more than 11 per cent since the beginning of the year. Indeed, there was a smack of panic as fund managers who have been dithering about buying gilts felt they could no longer afford to miss the fun. The Bank of England has managed to fund pounds 29bn of a predicted pounds 50bn borrowing requirement even though we are little more than a third of the way through the financial year.

One result of this run-up in prices is that the yield on long-dated gilts - the nominal fixed interest payment as a percentage of the capital value - has sunk by more than a point since the New Year to 7.4 per cent. This in turn makes the dividend yield on equities more attractive. So cash flows into both gilts and shares. Although there is no mechanical relationship between bond and equity yields, they will tend to move in line.

The first chart shows how the relationship between inflation and share prices through UK market history. Since 1918, when Barclays de Zoete Wedd's gilt-equity study begins, the best-performing periods for British equities - registering an annual average return of more than 20 per cent after allowing for inflation - have been when inflation has been just 0 to 2 per cent.

Things are never quite so simple in economics, of course. If inflation is falling because of a squeeze on profits, share prices may look less frisky. But nothing has changed for earnings prospects in last week's sour data. Manufacturing output fell back in June, but this series should only be taken in doses of three months at a time. The second quarter is up 1.4 per cent, and the first up 2 per cent. By the standards of the last recovery, when manufacturing output was virtually flat during 1981 and 1982, this is impressive growth.

Nor is it sensible to worry yet about the reversal of the five-month fall in unemployment. Overtime working is down, but that is probably because employers are confident that the recovery will be sustained and are hiring instead. Manufacturing employment has now risen for two successive quarters for the first time since the boom of 1988, which corroborates the strong signals from output. Vacancies are also up.

The jobs performance in manufacturing is particularly encouraging because it was rare even in years of normal growth during the 1980s to have any rise in factory employment. So the figures are telling us that activity is still rising strongly. Moreover, output is rising more strongly than home demand, which is precisely the pattern we need if the recovery is not to be derailed by imports and a burgeoning trade deficit.

With little change in the prospect for earnings, it is the good news on inflation and interest rates that has been driving the financial markets. The Bank of England inflation report on Tuesday pointed out how far the picture has improved. Last October, the Bank was anxious about whether the Government would be able to steer inflation within its 1- 4 per cent target range. Its central forecast is now 3 per cent.

In the short term, there is hardly a cloud on the horizon. Commodity prices are subdued. Opec is unlikely to succeed in pushing the oil price to a new plateau when several members are breaching their quotas. Some of the initial devaluation of the pound after it was ejected from the exchange rate mechanism has now been reversed: sterling is down 10 per cent overall, largely due to the rise of the dollar. (The fall against EC currencies is just 4 per cent, while it is 16 per cent against non-EC currencies). So import price rises are containable.

The best news of all comes from the UK labour market, where both earnings and pay settlements continue to ease. For businesses as a whole, pay accounts for some two thirds of all domestic costs. (Bought-in stock contains other businesses' labour costs). Earnings growth is thus the best possible measure of core inflation. If earnings growth is low, inflation is likely to be low.

I argued last summer that most people were still too gloomy about earnings, and that we were pioneers in a new territory of low inflation. I expected settlements to subside to 3.5 per cent or even below. In fact, settlements are now a little over 2 per cent. This is less than half the low point of 4.8 per cent during the 1980s. For earnings (which include overtime and so on), the rise over the year is 3.5 per cent. The lowest underlying rate in the 1980s was 7.5 per cent.

We are probably now near the bottom of the pay-earnings cycle. As demand revives, so will pay drift. Headline inflation is now at 1.2 per cent, flattered by interest rate cuts since last September. As it gradually edges up, it will encourage higher settlements. But high unemployment will ensure that the rise is moderate. Even 5 per cent earnings growth would be half paid by the trend of rising productivity, so that prices would tend to rise by just 2.5 per cent.

But the City is still sceptical about the longer run. It is possible to work out what the market really thinks about future inflation from the prices of different Government securities. (The extra yield that the Government has to pay on bonds that are not linked to the retail price index represents a compensation for the expected erosion of the value of capital by inflation).

Broadly, the market was assuming average 4 per cent inflation over the period to 2015 before we left the exchange rate mechanism last September. In the immediate aftermath, the inflation assumption leapt to a little more than 5 per cent. In the spring, the markets worried about the impact of devaluation and projected 5.5 per cent. And now they are back to 5 per cent.

Some of this premium is payment not for the loss of value due to inflation, but merely for the risk that there might be a loss of value. There is only one shortcut that might calm those fears, which is to put monetary policy into the hands of an independent central bank. If Britain could shave just 1 percentage point off long-bond yields - half the difference with German yields - the Treasury would save pounds 940m every year in financing costs on this year's and next year's budget deficit alone. Political control has a high price.

(Graphs omitted)