The BoE is likely to pick up the baton again in 2013, helping keep inflation expectations bubbling along.
Combining the BoE’s estimates with our own policy-looseness analysis shows how accommodative policy will need to stay. It suggests that, given the fiscal squeeze, 2013 would require no more than a further £25-£30bn in QE (to a cumulative £405bn) to loosen the overall policy mix from 2012.
Yet, if the economy lapsed into a protracted recession, at least £400bn extra QE would be needed (to a cumulative £805bn) to return to the extreme policy looseness of 2009 and 2011, when QE was last run. In which case, the BoE would then account for almost three quarters of conventional gilts holdings.
In practice, the BoE will probably settle somewhere in the middle. But, by avoiding ‘QT’ (sales of gilts back into the market) the UK will just be deferring correction of what has been an unmatched long-term loosening that easily predates the crisis. No major country has net loosened its overall policy more than the UK. And, it is no coincidence – given the subsequent inflation risk – that countries with the loosest policies generally suffer the softest currencies.
This suggests the pound could, as a second-round effect from QE, be a more potent channel to inflation than QE itself.
A softer pound would offer some relief to growth, and reverse some of the fall in goods-price inflation. But, even if not, it is the less exchange-rate sensitive services-sector that stands to generate more inflation. BoE Governor Mervyn King’s preferred, CPI ex-VAT inflation measure may be cooling as the pound’s (temporary) safe-haven status soothes goods-price inflation, but various charges and pipeline costs have been contributing to keeping services-price inflation far stickier, at 3% to 4% year-on-year.
Our RPI scenarios all incorporate, for example, the ongoing spate of electricity and gas price hikes (a weighted average 8% month-on-month) between October and January 2013, as well as January 2013’s average 6.2% mom on rail fares. These will bloat inflation but cap discretionary spending.
But, we are especially watchful of food and measurement changes. With food and catering making up 16% of the RPI basket (19.5% of CPI), the year’s unseasonable weather (US drought, UK floods, Russia and Latin America’s crop shortage) could, after the usual time lags, raise our projections.
As a guide, our simulations quantifying these two contrasting forces suggest that six months of food-price inflation (in conjunction with the ongoing utility/rail-price hikes) would in 2013 offset the potential, up to 0.75% point, RPI cut from removing the RPI/CPI distortions currently being considered by the ONS.
Uncertainty on this will persist ahead of January’s announcement, requiring sign-off by King and possibly Chancellor George Osborne.
Alternatively, in the less likely event that food prices stay muted, such that RPI reform is not offset, RPI inflation could drift down to just under 2% yoy in mid 2013. Yet, in bond terms, even if this outcome materialises, it looks largely priced in by short-dated ‘break evens’ currently offering barely 2.2%.
This suggests short-dated index-linked government bonds are under-pricing inflation risk. And especially if they’re also under-estimating QE in 2013 and fiscal slippage, which we suspect they are. Because to the authorities, the alternative – deflationary expectations – is just not acceptable.
