Headline UK inflation fell sharply in April to 8.7%, down from 10.1% in March, hitting single figures for the first time since August 2022. However, the drop in the headline rate provided little cause for celebration. Most of the fall can be attributed to base effects from last year, when gas and electricity prices soared as a consequence of the war in Ukraine. Especially worrying are food prices, which continue to rise at record highs, while services inflation remains very sticky, sparking fears that price pressures could continue in the near-term.
April’s headline figures were disappointing both for the Bank of England, which had expected a fall to 8.4%, and for respondents to the Reuters Poll, who had expected a fall to 8.2%. The picture on core inflation was particularly troubling, with the twelve-month rate climbing from 6.2% in March to 6.8% in April — respondents to the Reuters Poll had expected it would remain unchanged. The battle against high inflation in the UK is far from won.
Whereas the US and euro area are showing tentative signs of core inflation peaking by now, in the UK it appears to be gaining momentum. The two-year gilt, which can be considered a good proxy for monetary policy expectations, has risen to 4.4% — levels last seen in September during the Truss administration. Were the Bank of England to continue to raise rates, that would indicate a significant divergence with respect to other major central banks that are expected soon to halt their hiking cycles.
The UK economy is in the early stages of a wage-price spiral, with wage inflation and price inflation feeding off each other. Private sector wage growth was 7.2% in the twelve months to March, while public sector wages, which were lagging, have caught up quickly over the past few months. With little or no productivity growth, that is far from consistent with the 2% inflation target and points to further upward pressure on core inflation in the months to come.
Part of the reason why inflation has remained so high in the UK is because the economy has performed better than expected. The UK is not alone in this story: last year, many forecasters expected recessions across the board, as a combination of declining real wages and higher energy prices was thought likely to culminate in a squeeze on household spending, accentuated by the lagged impact of monetary policy tightening. However, consumers across Europe continued to spend, with their incomes boosted by generous government support, while US consumers dipped into their pandemic savings.
The financial market reaction to the inflation news has been blunt, with ten-year government bond yields spiking to levels not seen since last October, when gilt yields soared after chancellor Kwasi Kwarteng’s ill-fated mini-budget endangered the UK’s financial credibility and sent panic ripping through markets. UK bonds now pay a premium of 50 basis points over the equivalent US notes, something that has not been seen since the last decade. The British pound also spiked to its highest level against the euro since December, although it soon softened amidst investor concerns that elevated inflation and interest rates would lead to a recession down the road.
The UK economy is now expected to operate with positive real rates over at least the next two years. If we make an adjustment for the upward bias in UK RPI compared with CPI measures in the UK and elsewhere, then the expected two-year real rate, which had been negative — often substantially so — throughout last year as inflation moved into double digits, may now be as high as 1.9%. That appears close to investors beliefs about the neutral real rate of interest, to the extent that is reflected in the real forward rate curve, with real forward rates averaging around 2.0% beyond ten years, after making an adjustment for the upward bias in RPI described above. On that basis, it is unclear to us that either current or expected UK policy is tight enough. This is an issue that Fathom will revisit in our upcoming Global Outlook, Summer 2023 — highlights will be available to Refinitiv subscribers in Chartbook.
The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
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