The Kondratyev cycle is a 54-year fluctuation in wholesale prices comprising 27-year upswing and downswing phases.

The cycle is global in nature but can be tracked conveniently using UK WPI information, which extends back to the 18th century – see first chart. The cycle is evident in price levels until the second world war and inflation rates thereafter (reflecting the 1930s demise of the gold standard).

The last cycle peak in 1974 was followed by a 27-year downswing to a trough in 2001. WPI inflation is now a decade into another 27-year upswing that is scheduled to peak in 2028.

The second chart explores the relationship between the Kondratyev cycle and US Treasury yields. Yields peaked in 1981, seven years after the inflation peak, and retested their high two years later. The secular bond bull market began in earnest in 1984, nine years after the Kondratyev peak.

This lag may reflect the behaviour of monetary policy-makers, who took a long time to be convinced that the trend in inflation had reversed and they could afford to loosen.

Recent developments are the mirror-image of the 1970s / 1980s. Consistent with the timing at the peak, the Kondratyev cycle trough of 2001 was followed by a low in Treasury yields seven years later in 2008. This low was retested and rejected last year, nine years after the inflation trough.

The suggestion, therefore, is that the interest-rate cycle is in a similar position to 1984 but with yields now about to embark on a sustained rise. The trigger for such a trend change could be a hawkish shift in monetary policies during 2011, led by emerging economies, as the well-advanced upswing in WPI inflation extends and broadens out to consumer prices.

In May 2009, the Bank of England forecast that CPI inflation, then 2.9%, would fall to 0.7% in the second quarter of 2010. The outturn was 3.5%. In the August 2010 Inflation Report, the Bank presented an analysis of this forecasting "miss". It concluded that one-third of the error reflected higher-than-expected energy prices, with the remainder due to a combination of underestimation of upward pressure from sterling weakness and rising VAT and overestimation of the disinflationary impact of the negative "output gap".

To make one huge forecasting mistake may be regarded as a misfortune; a repeat performance this year would seriously damage the Bank's credibility. Such an outcome, unfortunately, is probable. The same August Inflation Report forecast that CPI inflation would fall to 2.8% in the second quarter of 2011 on the way to 2.2% by the fourth quarter. Based on recent trends, these numbers may be overshot by 1.0-1.5 percentage points – the chart shows a possible profile.

What has gone wrong this time? The Bank cannot blame the latest VAT rise, the impact of which was supposedly incorporated into the August forecast. It will no doubt attribute a significant portion of the overshoot to higher commodity prices but were these really unpredictable? Commodity costs have been positively correlated with emerging-world growth in recent years and the latter was widely expected to remain strong. The Bank's default assumption of stable prices (or evolution as implied by futures markets) represents a dereliction of analysis.

Three more fundamental criticisms, however, can be made. First, the Bank, in time-honoured fashion, has misread monetary developments. Most MPC members pay little attention to the monetary side of the economy but those who do, including Governor King, have wrongly concluded that slow broad money growth precludes sustained high inflation. As argued in previous posts, however, this ignores the negative impact on the demand to hold money of the negative real interest rates imposed by the Bank. Weaker money demand has resulted in an inflationary monetary excess despite low supply expansion. (This argument has been ignored in the recent exchanges between Sunday Telegraph columnist Liam Halligan and leading monetarist Professor Tim Congdon about the inflationary impact of the Bank’s policies.)

Secondly, the Bank has continued to place unwise reliance on "output gapology" despite well-known difficulties in measuring economic slack and uncertainty about its disinflationary impact. A post in January last year presented evidence suggesting that GDP was then only about 2% below its trend or potential level versus an OECD estimate of a 7% gap – probably representative of the Bank's thinking at the time. The sensitivity of inflation to the domestic gap, meanwhile, may have fallen significantly since the last recession in the early 1990s, reflecting the globalisation of the economy.

Thirdly, the Bank has underestimated the impact on expectations of the inflation overshoot and its own failure to react. Judging by survey evidence, firms and retailers plan to pass on the bulk of recent cost increases and the VAT hike to buyers, suggesting confidence that the MPC will continue to accommodate above-target inflation. The Citigroup / YouGov measure of household longer-term inflation expectations (i.e. over the next five to 10 years), meanwhile, has surged to 3.8%, a level exceeded in only two months since the survey's inception in 2005. This pick-up appears to be feeding through to pay settlements, with private deals moving up towards 3%, according to research firm Incomes Data Services.

Current inflation difficulties would be less severe had the Bank raised interest rates in mid-2010, as suggested here; this would have boosted the exchange rate, thereby restraining import cost increases, while bolstering the MPC's inflation-fighting credibility and firing a warning shot across the bows of firms planning price hikes. With the relationship between banks’ funding costs and Bank rate much weaker than in the past, such an increase would probably have had limited impact on lending rates. The net effect, indeed, may have been to support economic growth by moderating the inflation squeeze on real income and money supply expansion.

The MPC's Andrew Sentance, who has voted for higher rates since June, is winning the argument and deserves greater support from his colleagues. The December minutes revealed a small shift towards increased inflation concern and the "MPC-ometer" model suggests that this will continue at this week's meeting, with a possibility of another member supporting a hike. Poor economic news (fourth-quarter GDP growth is released on 25 January) or a set-back in markets could intervene but Dr. Sentance may yet achieve his aim of moving rates higher before his second MPC term expires at the end of May.


The OECD's leading indicator indices for November signal a short-term upswing in global industrial momentum, validating a forecast made last July on the basis of monetary developments. The improvement, however, does not extend to the beleaguered EMU-periphery.

The chart shows six-month changes in combined industrial output and a leading index for the group (i.e. Italy, Spain, Portugal, Greece and Ireland) together with a "leading indicator of the leading index", which heralds turning points. The six-month decline in the index accelerated further in November and the double-lead indicator has yet to signal a bottom.

This weakness is consistent with an ongoing contraction of real narrow money discussed in a previous post.

These developments suggest that the recent fall in EMU-periphery industrial output will gather pace in early 2011. Economic weakness is likely to undermine fiscal consolidation plans, in turn ensuring that the sovereign debt crisis rumbles on.

UK institutions' money holdings are at their lowest level since 2006, implying less fire-power to buy gilts and other assets.

Insurance companies' and pension funds' holdings of bank deposits and short-term money market instruments stood at £140 billion in September 2010, down from a peak of £180 billion in September 2008 and the lowest since June 2006, according to the Office for National Statistics.

The liquidity ratio (i.e. money holdings as a percentage of the value of financial investments) was 5.6% in September, down from an 18-year high of 8.6% in September 2008 and the lowest since March 2002 – see chart.

Institutions generally target a stable proportion of money in portfolios over the medium term, increasing investment in markets when the liquidity ratio is high and vice versa. Historically, the level of the ratio has been positively correlated with subsequent real equity market returns, as discussed in a post in early 2009.

At 5.6%, the liquidity ratio is below its average of 6.4% since 1987. Institutions have been directing the bulk of new investment into gilts recently, buying £15 billion in the year to September. Weaker institutional demand could add to upward pressure on gilt yields from a slowdown in overseas buying – see post last week.