Markets are overly pessimistic on the outlook for inflation in the UK, says Capital Economics

Markets believe the Monetary Policy Committee (MPC) will wait another year before raising rates and even then it will take another eight years to reach 2%, according to Capital Economics.

They are however overly pessimistic, the think-tank wrote in a research report e-mailed to clients on Monday.

Analyst Samuel Tombs explained: “While there are reasons, such as the re-intensification of the fiscal squeeze, to expect the MPC to raise rates more gradually than in past recoveries, we doubt that the pace of tightening will be quite that slow.

“The economic recovery still has plenty of momentum and pay growth appears to be picking up in response to the decline in slack in the labour market. What’s more, an even longer period of 0.5% rates would risk stoking asset price bubbles in certain markets.

“Accordingly, we think that Bank Rate could rise to 1.5% or so by the end of 2016, lifting Gilt yields from their super-low levels and enabling sterling to rise a little further against the euro.”

In tandem, Capital Economics released another report claiming that a prolonged period of mild deflation in the Eurozone would have much less of an effect on equities than was the case for Japan’s stock market between 1999 and 2012.

Chief markets economist John Higgins said: “We suspect that the stock market in the Eurozone would not suffer the same fate, given its much lower initial valuation.”

“The growth rate of nominal GDP is likely to be negative in a mild deflation, even allowing for some growth in real GDP.

“In practice, though, the growth rate of stock market earnings tends to differ substantially from the growth rate of nominal GDP due to changes in margins and corporate output, as well as accounting treatment, industry coverage, overseas profits and fluctuations in share count.

“In Japan’s case, the annual growth rate of stock market earnings per share (EPS) averaged 7% between 1999 and 2012. We don’t assume that the growth rate of EPS would be as fast in the Eurozone in the event of a prolonged period of mild deflation there, but it could certainly still be positive.”

The firm reasoned that should “provide reassurance to investors in the euro-zone, where the P/E ratio today is much lower than in Japan in 1999”.

Higgins added: “If we are wrong, though, the market could actually do quite well. After all, equities in Japan have certainly benefited more recently from the collapse in the yen that has resulted from the audacity of the BoJ.”