Inflation pressures expected to relent in 2009

Consumer price inflation rose to 2.4% above the Bank of England's target rate last month, with the now familiar infusions of higher food and energy prices lifting the headline CPI number to a higher-than expected 4.4%.

The month-on-month increase from June (0.6%) was the largest since records began in 1997, with a surprisingly strong rise in food prices adding 0.3% to the annual rate.

Mervyn King will be writing another letter to the Chancellor to explain away this latest data, however, this won't bring inflation down. The mathematics might though; even if electricity, gas and petrol prices stay at their current elevated levels, inflation should fall significantly next year as recent sharp price increases begin to drop out of the year-on-year numbers. And that's before we begin to take account of the sharp fall in the oil price since mid July.

"There's a general slowdown underway. Oil has come down because demand has fallen," comments Chris Burvill, manager of the Gartmore Cautious Managed Fund.

"We expect the headline inflation numbers to remain poor for the next six months, but beyond that there is a high probability that inflation will start to fall."

Chris's view is backed by a the recent sharp decline in the gap between conventional and index-linked gilt yields, which implies that inflation expectations have been falling even as the headline numbers have deteriorated.

Chris took advantage of increasing fears about inflation in June by reducing the Fund's exposure to index-linked gilts.

"We decided to sell some of our index-linked holdings having benefited from a year of very good performance and as we saw yields dropping to unattractive levels," says Chris.

The move proved timely, as inflation fears have eased somewhat since June. However, falling inflation expectations are not enough on their own for Chris to relinquish his defensive stance. The Cautious Managed Fund is holding close to its lowest-ever equity exposure (39% of the portfolio)¹ with high weightings in sectors with defensive qualities, such as pharmaceuticals, and a defensive bond portfolio consisting principally of gilts or gilt equivalents.

"A lower oil price is definitely a positive for the market in the short term, because it is helping to ease inflation and interest rate fears, but all it really does is confirm that the economic background is worsening," Chris cautions.

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