investment viewpoints
What inflation will cost the UK
In the UK, the significant upside surprises in core inflation for April and May, as well as accelerating private sector wages, signal that the risk of a wage-price spiral is gaining momentum.
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What makes the UK situation different?
Historically tight labour-market conditions and persistently high realised inflation are emboldening workers to command higher wages. Those developments have triggered a dramatic repricing of BoE policy-rate expectations.
The BoE year-end base rate expectation has shot up 1.5% over the past couple of months and is now expected to rise to close to 6% from 4.5%, currently. The situation appears similar to that of the US or the Eurozone, given the global inflation shock has impacted economies at large across developed and emerging markets. However, the UK economy shows important singularities that help explain recent volatility exemplified most spectacularly during the short period under former prime minster Liz Truss.
The UK is what is called in economics a small open economy: one participating in international trade but not influential enough to impact world prices, incomes or interest rates. Others include Switzerland and New Zealand. Economies such as these have entered the inflation shock with certain disadvantages, such as exposure to both imported inflation and higher currency risk. In the UK, this is likely to keep gilts under pressure, with real yields higher than in the US and Eurozone. Here we explain our view of the dynamics at play.
What it means to be a small and open economy
The dramatic bounce in core and services inflation over the past couple of months is concerning. More than 18 months into the BoE tightening cycle, UK core inflation pressures remain stubborn and broad-based. Many components of the this inflation basket continue to see significant upward pressures, particularly in goods sectors. Price pressures continue to increase in the services sector as well, with a 7.4% year-on-year increase. It is concerning, but not surprising.
The UK economy entered the inflation shock with the typical problems associated with a small and open economy. First, increasing import prices created an initial inflation shock. Then, from its peak to bottom between 2021 and 2022, sterling lost nearly 30% of its value – an extreme move followed by a partial recovery.
Still, currency weakness and imported inflation provided a more persistent spin to upside price pressures, which is typical of such an economy. Figure 1 shows the estimated rolling persistence of inflation across the G10 economies. On the chart, the commonality between open and closed economies is clear. But the persistence of inflation for smaller economies increases after an inflation shock and takes much longer to normalise than for larger economies such as the US and the Eurozone.
Currently, our estimates show that inflation in the UK is displaying an even higher persistence than the average small economy, adding to the challenges that the BoE is facing. It needs to deliver on the typical objectives of both a developed-market central bank and that of an emerging economy: lowering domestic inflation pressures, while stabilising its currency to avoid importing more inflation. One tool (interest rates) for two objectives is a known economic challenge if you believe in the Tinbergen rule, which asserts that a government seeking to achieve a range of policy targets must use multiple policy tools.
Figure 1: Inflation persistence by type of economy and in the UK
Source : Bloomberg, LOIM at June 2023. Reading note: this chart shows the rolling estimate of an autoregressive model of order 1. The higher the reading, the more persistent the inflation shocks.
With persistent inflation, interest-rate pressures remain strong
This means the BoE is doomed to hike rates probably more actively than any other central bank: with two sources of inflation to contain, real rates need to undergo a rapid normalisation. That is pretty much what happened over the past few quarters. Figure 2 shows how the change in the UK 10-year real yield has been much stronger than that of the US and the Eurozone. Between 2021 and 2023, the bottom-to-peak change in real yields has reached 4.7%, compared to 3% in the US and in the Eurozone. The Federal Reserve’s current pause on rate rises is unlikely to be mirrored in the UK, where the re-pricing of real rates continues.
Rising rates are rippling across the curve: gilt yields on the short-end are trading above the levels that were last hit during the September 2022 turmoil, triggered by the budget proposals of the short-lived Truss government. In the long-end, interest rates are a whisker away from the levels that triggered the BoE emergency bond-market intervention. In the policy decision-making process, the BoE – even more so than other major central banks – is forced to become reactive. It has to heavily discount the projections of its economic modelling and put increasing emphasis on realised inflation. In our view, the BoE is likely to keep hiking rates in the coming meetings to anchor inflation expectations.
Figure 2: Variations in US, Eurozone and UK 10-year real yields
Source : Bloomberg, LOIM at June 2023.
The coming mortgage shock
With the BoE base rate sitting at a 15-year high, the tightening of the mortgage market will be one of most effective transmission channels in the coming quarters. While the impact of rate hikes has been relatively muted so far, the increasing cost of mortgages is set to slow down overall demand among consumers and will support the BoE in regaining control over inflation.
Fixed-rate mortgages are the norm in the UK. However, they typically have a short maturity of two or five years. In the coming quarters, about 350,000 mortgages per quarter are coming up for renewal, amounting to about 3.2% of the 11 million mortgages outstanding per quarter. The large majority of those mortgages were on fixed rates of less than 2.5% and will be reset at rates well in excess of 5%.
The BoE is unlikely to be able to reduce rates for at least the next 12 months, meaning the impact on disposable incomes will be significant and will affect a broadening number of households. In our view, the intensifying pressures on disposable income will help the BoE will regain control over inflation as economic activity decelerates. All of that is presented in Figure 3.
Figure 3. UK fixed-rate mortgages coming up for renewal by initial effective interest rate
Source: ONS, Bank of England, LOIM at June 2023.
| Simply put, even with UK duration risk set to remain volatile, locking in the historically elevated sovereign bond yields on offer in major developed markets is increasingly attractive, in our view. |
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Our growth indicator held steady over the week. The situation in the US is that of a lower growth period while the Chinese recovery shows signs of stalling
- In line with the growth situation, few new inflation data releases this week (apart from the UK) mean our indicator continues to point to a global easing of inflation pressures
- Our monetary policy signal remains below its 45% threshold – a sign of a less hawkishness
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).
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