We have expected inflation to persist and to then settle around 3% to 4%, not the 1% to 2% we saw before the pandemic. The market has tended to always assume that inflation will return to its target of 2%.
But the reality is, we can’t predict for certain where inflation settles, as it depends upon many factors, including the stance of monetary policy.
Lessons from the past
There are lessons from the 1970s, the last occasion when inflation rose sharply. The countries that tightened monetary policy early on were more successful at keeping inflation in check, namely Germany, Switzerland and Japan.
Clearly, current monetary policy in the UK has been slow to anticipate or even react to the present rise in inflation so another lesson from the 1970s may be more relevant for the UK now: the pain inflicted upon an economy by inflation, both directly as higher inflation dampens spending power, and also as policy has to be tightened to squeeze the economy in order to curb higher inflation.
Last year, monetary policy should have been tightened – at a time when the economy would have been able to cope with such tightening. Instead, policy was loosened. Rates have already risen since December from 0.1% to 1.0% and the UK is now in the early stages of reversing Quantitative Easing (QE) via Quantitative Tightening (QT). Yet, not only has policy to tighten further to correct for last year but it needs to get on top of the inflation process that is already underway.
Consumer price inflation reached an annual rate of 9% in April, and retail price inflation 11.1%.
Have inflation expectations peaked?
Remarkably, given the importance that the Bank of England attaches to inflation expectations, the Governor stated in a widely reported testimony recently to the Treasury Select Committee that the Bank was “helpless” to control inflation, which is a crazy thing to have said.
For a start it will likely feed inflation expectations. The message should have been to reassure the public that inflation would be brought back under control, to give confidence and to help curb inflation expectations. Also, it is not true.
While the initial inflation shock may have been a supply-side one, a significant part of the current rise in inflation is not, and tightening monetary policy is aimed at squeezing the economy to dampen rising costs, wages and prices.
How high will rates go? Currently 1% policy rates are too low. The market expects six more hikes of 0.25% to bring the interest rate to 2.5% by the first quarter of next year. Rates would still then be low compared with likely inflation. But the economy may prove vulnerable to rising rates. Reuters reported that 1.5 million people would move off two-year fixed rate mortgages this year and the same number next. In the US, the Federal Reserve has talked of “negative feedback loops” with the US economy impacted as rates rise there; the same may happen here.
Interestingly, and importantly for a gauge of market sentiment, the cost of protecting against future inflation may have peaked. For instance, in the US bond market, five-year break-even inflation rates[1] peaked at 3.73% on March 25th, and by the end of last week were 2.90%. Currently, US consumer price inflation is 8.3% and the Fed’s preferred measure, the PCE deflator is 6.6%.
Likewise in the UK, market inflation projections may have peaked. The UK five-year breakeven inflation rate was 4.07% at the start of the year, peaked at 5.05% in early March but by the end of last week eased to 4.48%.
This shift also reflects the change in market expectations to the developing weakness of the economy.
A recession seems inevitable
There is a current debate as to how to describe this, as economic forecasts tend not to suggest there will be two successive quarters of negative growth – the technical definition of recession – nor that the UK’s annual rate of growth will dip below zero.
However, in our view, two negative quarters of economic growth looks inevitable and a deeper downturn is possible.
The GfK measure of consumer confidence has fallen to -38. It was only once weaker at -39 during the financial crisis. A year ago it was -15. The deterioration in people’s view of their own finances over the next twelve months is worrying, from a net positive balance of 10 a year ago to a net negative 26 now.
The Purchasing Managers Index, a measure of business activity, has also fallen sharply, from 58.2 in April to 51.8 in May. It is still above the 50 that marks the threshold signalling growth although it could fall through that next month.
In this environment, a tighter monetary and looser fiscal policy is needed. But as we have noted previously, while the direction of monetary policy is tightening via higher rates and QT, the speed, scale and sequencing of this tightening needs be influenced by economic conditions. Monetary policy should not be on autopilot.
Also, a fiscal stimulus is needed and appears inevitable. This needs to include help to those in difficulty and to offset the impact of current high fuel prices, thus being timely, targeted and temporary. I also think there needs to be help for the squeezed middle, although this seems unlikely, with the Treasury worried that an easing in fiscal policy will feed inflation.
But with domestic demand already easing, such worries appear overblown and fiscal stimulus is necessary to minimise the downside economic risks and also to reduce the possibility of a sterling crisis. Short positions against sterling have risen recently, and it requires both a credible combination between monetary and fiscal policy and effective communication of that policy to reduce those risks attached to sterling.
Yet even though an easier fiscal stance is needed and likely, it is the scale of monetary tightening to curb inflation and likely economic weakness that will continue to weigh on financial markets.
Please note, the value of your investments can go down as well as up.
[1] Breakeven inflation rates are derived from the current relative yields on offer from regular government bonds and those whose coupons and principal are lifted in line with realised inflation. In this way, the breakeven rate represents the bond market’s estimate of future inflation, albeit subject to some market technicalities, such as liquidity.
