The most recent statistics on UK inflation have been alarming. The Bank of England was pushed into a 0.5% rise in interest rates, and there are still fears they will have to go further. Has the UK developed an embedded inflation problem? Could this see rates lift to worryingly high levels?
First, the good news. The May inflation print may have been shocking, but there are still ‘anniversary’ factors that are likely to bring down inflation in the next few months. Clive Beagles, senior fund manager, JOHCM UK Equity Income, says halving inflation to about 5% should be achievable by roughly the end of this year.
He says: “One of the reasons why UK inflation has been disproportionally higher than in other economies is simply because we’re more dependent on external energy sources. That means we imported a lot of inflation through energy, but we’re about to see a big step down there as the latest price cap comes into force. A reduction in energy prices should lead to a fall in food prices, which will support lower inflation too.”
Beagles also points to the deflationary impact of a stronger pound: “Currency is a pretty good reflection of global sentiment, and we’re at a one-year high against both the US dollar and the euro. Inflation is coming down significantly in Continental Europe and the US, which will help to reduce our imported inflation.”
However, he admits that any further improvement in inflation will be far harder won. Peter Spiller, manager of the Capital Gearing portfolio, agrees. He currently holds around 45% of the trust in index-linked bonds, of which around half are in the UK. This is a reflection of a significant change in pricing in this part of the bond market, but also reflects his view on the likely trajectory of inflation: “Our view is that inflation will be stickier and more persistent than the consensus believes.”
He says the ‘anniversary effects’ will go away, improving headline inflation but adds: “The key is core inflation. We believe that is driven by changes in wages and we do not believe that wage inflation will go away until unemployment is significantly higher than it is today.”
Of the major markets of the US, Europe, Japan and UK, the UK is the only one where core inflation is rising. It excludes volatile energy, food, alcohol and tobacco prices, so won’t benefit directly from falls in oil and gas prices. The real factor supporting core inflation is the rising costs for services – air travel, leisure activities and so on – which has been supported by a tight labour market and rising wages. There appears to be little signs of these trends reversing, particularly as strikes continue in the public sector.
Royal London Asset Management’s senior economist, Melanie Baker, says that while there is a fair bit of ‘noise’ in the core inflation statistics, it is difficult to see any significant downward pressure: “Although air fares and tickets to live music events will have played a role in that and may well prove temporary upward inflation drivers, it was striking how little downward pressure you could see across the main services components generally. Pay growth remained strong on the data released last week too.”
There are also global reasons why inflation could remain higher in the UK. Spiller says: “We’re moving from the ‘great moderation’, when the combination of globalisation and technology provided powerful forces for deflation, so that anticipated recessions could be prevented through stimulus without inflationary consequences, characterised by zero interest rates, to a very different world, where it is characterised by the re-emergence of business cycles, of inflation that moves with those business cycles, but is centred on a median level that is significant higher than the central bank targets.”
This is a view echoed by the BlackRock Investment Institute: “We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years. Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation and the transition to a lower carbon world.”
Against this backdrop, the likely policy would be to continue raising rates. However, even amid the Bank of England’s Monetary Policy Committee, there have been dissenters on the right course of action with Swati Dhingra and Silvana Tenreyro voting to hold rates at 4.5%. It is worth noting that the Bank of England itself says around two-thirds of the impact of higher interest rates has yet to be felt in the market. This would suggest that further rate rises could be unnecessary and may be actively damaging.
Beagles says there’s a potential for policy errors if the central bank focuses entirely on the rearview mirror. He adds: “Inflation is falling already and will fall further, even if the MPC does nothing. There’s also a delay in the transmission to consider as the proportion of five-year-fixed-rate mortgages has risen from 20% to 50% in the past decade.” The cost of rents is also increasing, leaving UK households with less and less disposable income in their pockets.
Interest rate hikes have been described as a piece of elastic attached to a brick. The elastic stretches increasingly longer until the economy is smashed by the brick. This is the danger for the UK economy as it stands. It is a precarious moment, even if inflation starts to drop from here.
