Jeremy Warner's Outlook: Thanks to Far East, inflation is still sleeping

Water's gold mine; HBOS revitalised
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The Independent Online

Inflation is rising again, both here and in the United States. Set against the backdrop of global currency turmoil, it makes it harder than ever to predict the future course of interest rates. Rates rose again in the US last night, albeit from a still extraordinarily low level, and judging by yesterday's inflation numbers for November, they may yet rise further in Britain too, to a level where they really begin to hurt before they start going lower again.

Inflation is rising again, both here and in the United States. Set against the backdrop of global currency turmoil, it makes it harder than ever to predict the future course of interest rates. Rates rose again in the US last night, albeit from a still extraordinarily low level, and judging by yesterday's inflation numbers for November, they may yet rise further in Britain too, to a level where they really begin to hurt before they start going lower again.

Spurred on by higher utility prices, the consumer price index surged 0.2 per cent last month, taking the annual rate of inflation to 1.5 per cent. That hardly seems enough to worry the horses, yet it is to the "old" retail price index, which takes some account of the effect of still rising house prices, that we must look for a better guide to what is really happening to inflation.

This is now motoring along at 3.4 per cent, where it is expected to remain for much of the next year. As the generally accepted benchmark for pay awards, this is the measure of inflation that will be giving the Bank of England the greater headache. All it would require now is a collapse in the value of the pound, which with still growing current account and budget deficits is more than possible, and inflation would start really racheting up.

That inflation is still relatively tame is almost wholly down to deflating product prices. The cost of clothing and footwear, for instance, was 5.2 per cent lower in November than a year earlier. The price of services, meanwhile, is in most cases rising at rates that seem to belong more to the 1970s and late 1980s than today's supposedly inflation free world.

This two speed inflation rate has long seemed to me to pose serious questions about the appropriateness of current monetary arrangements. The Bank of England sets interest rates to control inflation, yet their primary effect is on demand. Only by increasing or lowering demand do rates effect inflation. In the days of closed national economies, the effect would be powerful and immediate. If demand exceeded supply, then rates would rise until the two were brought back into balance. The same would apply in reverse. Yet in today's globalised economy, there is now an almost limitless source of new supply from the fast-industrialising regions of Asia.

The upshot is that the Bank no longer has to control demand in order to limit inflation, or not by as much. The deflationary brake is applied gratis, as it were, by the Far East. This has allowed the Bank's Monetary Policy Committee to run a much looser monetary policy than would otherwise have been the case. This in turn has allowed for a potentially dangerous build up of domestic credit to on average 140 per cent of household incomes at the last count.

In the past, a credit boom of such enormity would have been highly inflationary. Yet the effect of price deflation out of the Far East has meant that instead this excess of demand has found its outlet in the creation of asset bubbles - first equities, then house prices and now commercial property. The other effect is a widening current account deficit, as cheaply priced goods from abroad are sucked in to feed ever growing demand. Monetary policy is already being set in a manner deliberately designed to take the heat out of the housing market - rising house prices being the most obvious manifestation of excessive demand in the economy.

Yet there is still a confusion at the heart of policy which has yet to be properly resolved. Is it appropriate for rates to be set according to a measure of inflation as much influenced by the industrialisation of the Far East as what's happening in our own domestic economy? If the result is an ever widening current account deficit and an unsustainable house price bubble, then perhaps not. For obvious reasons, you won't find the Chancellor peddling that line of argument. It would interfere too much with his exaggerated gloating.

Water's gold mine

Come on in. The water's still lovely, provided you happen to be on the right side of the meter. Since the industry was privatised 15 years ago it has proved a goldmine for investors. The 10 big water companies have repaid their capital back to shareholders many times over, the sector has outperformed the rest of the market by 50 per cent and, no matter what the regulator has thrown at it, the dividend tap has remained fully turned on.

United Utilities, the water supplier for the North-west, signalled yesterday that nothing is about to interrupt that blissful state of affairs. In accepting the regulator Ofwat's latest price controls and committing itself to maintain dividends in real terms, UU has ensured it remains one of the highest yielding income stocks in the All Share Index for the next five years. Depending on the performance of its unregulated businesses, which sell call centre services to outside clients among other things, the returns to shareholders could be even higher.

Towards the end of the current five-year control period, UU gave shareholders a nasty surprise by tapping them for £1bn rights issue to pay for water clean-up programmes in the North-west. John Roberts, UU's chief executive, promises no such repeat over the next five years. Indeed, Philip Fletcher of Ofwat has been so generous to UU that it can afford to invest £2.9bn in its water network, pay the interest bill on its borrowings and still have enough cash to ensure the dividend payout keeps pace with the cost of living. Water utilities are now the closest thing to a gilt-edged stock that exists outside the government bond market.

Customers, on the other hand, will see their bills going up by rather more than inflation - by 4.5 per cent a year in real terms between now and 2010, in fact. For that, they are promised cleaner and more reliable water supplies together with fewer sewer floodings. Even the cockles on Blackpool beach can look forward to a less polluted environment.

Considering that the stuff falls free from the skies, the average household in the North-west might reasonably wonder why their water bill needs to rise by 20 per cent in real terms over the next five years. The generous dividend is one reason and while UU may plead that it needs to reward investors to raise capital, the balance still looks to be out of kilter. Water privatisation was one of the biggest City steals of the modern age, and there have been many of them. In the end the Government had virtually to give the water authorities away to get investors to buy. They've been laughing all the way to the bank ever since. It seems that little is about to change.

HBOS revitalised

James Crosby, chief executive of HBOS, has had quite a struggle convincing the stock market that his strategy for growth is one that is capable of delivering value for shareholders. For years now, his shares have limped along on an unflattering single digit earnings multiple. Now finally he seems to be making some headway in persuading the City he deserves better.

Yesterday's trading update made particularly encouraging reading. Margins are better than expected despite the drive for greater market share, cost increases are coming in well under target, and profits before tax this year will exceed consensus forecasts. What's more, even after funding all this growth and keeping dividend cover at two and half times earnings, there's still room for a £750m buy-back with the implied promise of more to come.

After the débâcle of the failed attempt to enter the bidding for Abbey National, the focus has returned firmly to organic growth, where HBOS is already demonstrating impressive headway in current accounts and other traditionally weak, non-mortgage areas of banking. This should keep Mr Crosby fully employed for at least the next two years. What happens thereafter, when these growth opportunities become exhausted, is a question for another day.

jeremy.warner@independent.co.uk

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