According to the final report of the independent review of UK economic statistics, led by Professor Bean, growth has been under-reported and inflation over-estimated in the United Kingdom for some time. This is largely due to the shift towards a services rather than goods based economy and rapid technological change.
“Growth has been better than reported while inflation has been lower,” said LGIM strategist Chris Jeffery during a briefing on Monday. “This has implications for investors. The implications for financial markets include helping to solve both the ‘bond yield conundrum’ and the ‘productivity puzzle’, while explaining ultra-loose monetary policy.”
“If we look at government bond markets, some believe that these are grossly overvalued,” Jeffery said. “But if inflation is lower, then the real yield on these assets is higher – in other words, some of that overvaluation simply disappears.”
On the positive side, faster growth means better productivity, which could convince investors of the sustainability and health of the recovery, Jeffrey added. However, the effects on equity markets is mixed – the fact that inflation is lower than expected could lead to increased volatility.
Meanwhile, the flip side of lower inflation is higher real commodity prices. “Investors sometimes look at commodity prices on a long-term inflation-adjusted basis. Lower inflation levels would therefore mean that current commodity prices look more expensive relative to their history,” said Jeffery.
He continued: “If we assume that inflation has been overestimated by 0.5% for a decade, then real commodity prices are approximately 5% higher than they seem.” If real commodity prices are higher than commodity investors think, there is less case for holding commodity as a hedge against declining purchasing power over time.
There is a dark side to the report’s findings too. If inflation is currently miss-measured, the debt trap is more serious than previously thought. ”With reported inflation already low, adjusting it lower moves us closer to a deflationary world, with existing debts harder to service and roll over, potentially leading to higher defaults,” noted Jeffery.
