Next week and the conundrum of inflation/deflation

With the focus on Europe, next week all eyes will be on the ECB, which makes its latest interest rate announcement on Thursday. Most expect a 25bps cut, from 1.00% to 0.75%, with a further cut to 0.50% by the end of this quarter.

As a backcloth to the ECB announcement, November industrial production (IP) data for Germany and France are due on Monday and Tuesday, respectively. It looks likely that IP for Euroland overall fell to 0.7% YoY from 1.3% in October – those numbers are out on Thursday.

December (EU harmonised) inflation data for France and Germany are also due on Thursday. French inflation is likely to have fallen to 2.1% YoY from 2.5%, with German inflation likely remaining unchanged from the advance estimate of 2.4% YoY.

In the UK, the Bank of England announces its rate decision and asset purchase target on Thursday. Almost everybody expects rates to be left unchanged at 0.50%, and a target of £275bn. UK trade balance and industrial production data are due on Wednesday and Thursday, respectively.

In reflecting on the Euroland position and agenda, it’s noteworthy that the austerity adjustment plans rely heavily on taxes on consumption (VAT and excises). In the past two years Spain, Portugal, Greece, Italy amongst others have raised their VAT rates as well as their excise duties. This trend looks set to continue this year, with steep increases planned in Italy, France and Ireland.

Clearly higher consumption taxes will affect inflation rates and we may expect the inflationary effects to be dramatic: the tax increases as implemented and in the pipeline will push both French and Irish inflation up by 0.9% and Italian inflation up by 2.2%. As a consequence, Euroland inflation will increase by 0.5% in the 2012-13 period. Most of the acceleration will take place this year, when increased direct taxation should be responsible for a 0.4% increase in EU prices.

This may lead to quite some confusion as to what’s going on, with the effects of increased taxation partly offsetting – in terms of the reported numbers – the deflationary effects of rising unemployment and falling commodities prices typical of a recessionary environment as envisaged for 2012. Without the VAT and excises hikes, we should reasonably expect EU HICP to fall close to 1% by the end of 2012, and instead with the fiscal interventions, reported inflation will likely not dip below 1.5% at the bottom point. This issue is even more pronounced for France and Italy, where the tax increases will fully offset the deflationary trend associated with a recession and keep the inflation rate well above the target 2% for the entire 2012.

So we have the bizarre reality that most people will feel that the climate is deflationary, as is to be expected with de-leveraging episodes, yet costs of living rise – truly a cocktail to depress demand and economic activity and hardly a propitious backcloth for risk assets. Yet an increase in inflation rates due to taxation changes has direct impact on carry income from inflation-linked bonds and other assets where revenues are linked to recorded inflation and this may be a year where utility profits are re-rated.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla