It’s tough to be a UK central banker

Inflation just keeps overshooting

There was a febrile atmosphere in the run up to the Bank of England’s (BoE’s) interest rate decision in June. May’s CPI inflation print – which was published the day before – came in considerably above expectations with y-o-y headline CPI staying flat at 8.7%, despite predictions of a fall to 8.4%, and y-o-y core inflation continuing its advance in the wrong direction. This meant that the UK’s headline inflation rate had exceeded expectations for the fourth month in a row (see Table 1), leading to widespread concerns about the potentially entrenched nature of UK inflation.

It has, of course, been widely noted that UK CPI, both the headline and core rates, sits considerably higher than CPI in the US and Euro Area (see Figures 1 and 2), so let’s take a moment to explore exactly what is going on here. 

The UK is not the only developed country with inflation higher than the Euro Area (for example, Sweden’s headline rate is currently at 9.7% y-o-y) yet even so the discrepancy with the Euro Area and the US remains notable. The differential between the UK and the US is fairly easy to discern. US indigenous production of oil and gas meant that energy prices were relatively insulated from volatility in global energy markets, which helped moderate household gas and electricity prices as well as energy input prices for goods and services in the US. 

The discrepancy with the Euro Area is more complicated, multi-faceted and not so clear cut. The nature of Ofgem’s price cap means that drops in energy prices somewhat lagged in the UK compared to the Euro Area. UK households will need to wait until July for electricity and gas prices to fall by 18% in absolute terms. But this does not seem to account for all of the difference between UK and Euro area inflation rates at the moment. The UK’s tight labour market – and the notable increase in labour inactivity rates since the onset of the pandemic – will no doubt also be playing a role, as this is a likely factor behind higher nominal wage growth in the UK versus the Eurozone. Other factors could also be playing an exacerbating role – for example, muted trade volumes in goods between the UK and EU and potentially a lagged inflationary impact arising from the depreciation in the pound during the autumn mini-Budget. 

Despite inflation repeatedly overshooting expectations, markets were still predicting just a 25bp rate increase in June but the BoE’s hike of 50bp up to 5% (the thirteenth increase in this cycle!) shows just how seriously rate setters are taking the UK’s seemingly stubborn inflation. It now seems inevitable that further increases in rates will occur this year, with base rate potentially peaking at 6% by year end if market expectations are anything to go by. Whether this would mean a recession is on the cards is an open question: the impact on aggregate real household disposable income will be limited due to the structure of the UK mortgage market (although the pain will potentially be severe for those 1.3 million households that will be re-mortgaging over the next twelve months), but of course businesses whose loans are mostly floating rate will in aggregate feel the pinch much more speedily. What’s for sure is that the next set of labour market and inflation figures will be keenly watched by market participants to see just how high interest rates could end up going. 

Hop, skip and a jump 

Markets tend to like using jargon to make things sound more complicated than they actually are. But this month’s activity can be summarised by the simple phrase in the heading, and we like simplicity.

The hop…

We are now getting to the stage where we know interest rates are closer to their peak compared to their floor, but rather than the unanimous hiking we have become used to in the past few months (and I am conscious I have perhaps sounded like a broken record in previous articles), we are now at the stage where there is some divergence.

In this case, the “hop” refers to central banks keeping rates on hold, with no forward guidance suggesting they expect to raise rates, or indeed cut them. A few central banks fall into this bracket, most notably we have seen the Bank of Japan keep policy unchanged citing its view that inflation will start to slow in the coming months. Governor Kazuo Ueda continues to warn that any tightening in policy could cause more harm than good, and the consensus points to no change in policy in the foreseeable future.

However some are speculating that by definition of Governor Ueda not officially ruling out any action at the next meeting in July, it could be a live meeting whereby we see some adjustments to its current Yield Curve Control (YCC) policy that keeps the 10-year Japanese bond yield trading within a tight range between -0.5% and 0.5%.

The Bank of Japan is not the only one, central banks across Eastern Europe, Asia and South America have been on pause for a while, likely waiting for the direction of the Federal Reserve before making any changes to their own policy. In China we have the complete opposite, with interest rates being modestly adjusted lower to try and support growth this year.

The skip…

This leads onto the skip, which has been in use all too often this month. This is in reference to a central bank holding rates steady, more to take stock of the impact of the interest rate hikes to date, with a view to then raise rates again at upcoming meetings.

The Federal Reserve falls into this category this month, after announcing as expected that the interest rate band will remain between 5.00-5.25% in June. However within the forecasts it expects that rates will need to increase by another 50 basis points this year – as per the median level shown in the “dot plots” below.

Inflation is falling, and came in as expected in the last reading for May. Annual core inflation stands at 5.3%, but was held up mainly by stickiness in used car prices and shelter (rent and owner equivalent costs). Expectations are for these to start softening soon as they tend to lag more real time data such as auction prices in the former and more timely housing measures in the latter. The latest employment numbers were also mixed with non-farm payrolls again jumping more than expected, adding 339,000 jobs in May, whereas a different household survey showed employment dropping 310,000. This survey is used to measure the unemployment rate which rose from 3.4% to 3.7%.

Stripping out the volatile numbers, the Fed will be pleased in some ways by the data, but doesn’t want to be complacent thinking its job is done. It is well documented around the Fed’s use of the phrase “transient inflation” during the upswing in inflation in 2021, which turned out to be a rather long transitionary period… It will want to avoid the same mistakes, and therefore sees raising rates further to slow growth as a lesser evil than the long-term consequences of above-target inflation.

This follows what we have seen from the Bank of Canada and the Reserve Bank of Australia, who were previously in the “skip” phase before raising their benchmark rates by 0.25% in their last meetings to 4.75% and 4.10% respectively. The reasons were understandable with inflation and employment running hot in both economies. For example employment in Australia rose by 76k in May versus an estimate of 17.5k. The Fed will be wary of the developments here too in its upcoming decisions.

Markets see a strong chance of Fed hikes resuming in July with 18bps priced in. No cuts are expected now in 2023, with around 100bps of cuts expected in 2024 – in line with the Fed’s forecasts.

The jump…

In this camp lies the central banks that continue to push on raising rates. Here we have the European Central Bank. The ECB caused no surprises at its June meeting, raising its relevant rates by 25bps – taking the deposit rate to 3.5% and the refinance rate to 4%. One thing noteworthy from President Christine Lagarde’s press conference was heavy hints that the ECB will raise rates again in July – the type of forward guidance central banks have stepped away from in recent months. Markets have got the hint too with another 25bp fully discounted in July, whilst tilting towards a further hike in September taking the deposit rate to 4,00%. In fact, markets are not ruling out rates above 4% in the winter. The Swedish central bank, the Riksbank, also join the ECB in this category with a 0.25% increase, taking the benchmark rate to 3.75%, and an increase in the pace of quantitative tightening. The decision here was more challenging, as the committee has to play an extremely weak currency (where a larger hike could have been justified) against a fragile property market.

And, the leap…

The Bank of England decision cannot really be described as a “jump”, but more a “leap” considering it surprised markets by re-accelerating tightening, increasing bank rate by 50bps to 5%. It wasn’t entirely unexpected by markets following farther evidence of sticky inflation in May’s numbers (annual core inflation increased again to 7.1%) released the day before. The decision was convincing too with seven members voting for the bumper hike, whilst the usual suspects, Silvana Tenreyro and Swati Dhingra, voted for no increase in rates. Worth noting that Ms Tenreyro will be replaced by Megan Greene in August, tipping the balance in favour of further hikes. The committee also opted to not push back against market expectation of further increases, and acknowledged that inflation is becoming more widespread across the economy.

We know from April’s inflation numbers and the later released wage growth figures that more is to come. Market expectations see the peak now at 6.25%, lofty to say the least, but whether it can be labelled as “frothy” is being repeatedly called into question. Markets see a hike in each of the next three meetings, and a chance of another 50bp hike in August. The environment feels slightly reminiscent of the mini-Budget period, although without the political chaos this time.

Although nothing to panic about, European gas prices have seen a pickup in volatility with prices spiking in recent weeks – coming from relatively low bases I must caveat. Supply outages in Norway and the Netherlands, coupled with increased demand due to the hot weather (thank goodness for air conditioned offices) has seen prices rise of its recent lows. The nearest to deliver UK natural gas future price now trades at 88p per therm, compared to 55p in early June. The European equivalent has increased to EUR 36 per megawatt hour from EUR 23. A market to keep an eye on, especially with ongoing caution around the upcoming winter. However overall demand still remains subdued, and inventory levels are high.

The Norges Bank also falls into this section with a 0.5% increase in June, as Handelsbanken expected, with heightened concerns over the strength of the Norwegian krone which has fallen near to record lows in recent months. The central bank however noted unfavourable inflation developments, even more than what is implied by a weak currency. The central bank forecasts point to two more hikes from 3.75% to 4.25% in the next two meetings, which is what Handelsanken forecasts too. 

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg.