UK Inflation May Fall Faster Than Expected
Despite domestic havoc, global price pressures are dropping off rapidly
A Nice Surprise
At the end of last week, we talked about how two main factors will shape the UK economy this year: employment and prices.
In my unrelenting mission to look on the bright side during these dark times (it’s instinctive, knee-jerk contrarianism, I can’t help myself), I wanted to share with you some details from a good piece on the latter by Simon French of Panmure Gordon, just out this morning.
“UK inflation — like the inflation seen across all major economies — has now peaked,” says the economist. This is not a controversial statement. October was the peak (at 11.1%, using the consumer prices index measure). The question now is how quickly does it fall and where does it get down to?
I’ve said it before and I’ll say it again now: everything that we’re complaining about here in the UK is happening, to a greater or lesser extent, in most major economies around the globe.
From excess deaths due (I assume) to medical backlogs created by lockdown and the pandemic, to inflation, to tight labour markets — every rich nation has some variation on these problems.
I’m not saying that our governance is great (it’s not, it’s woeful). I’m not saying that we don’t have political problems (we do). I’m not saying that we should just shrug our shoulders because everyone is in a similar boat (we need to get our heads out of our backsides and reform everything from the NHS to the planning system).
But we’re not alone. It’s important to understand this because otherwise, as an investor, you risk exaggerating the downside problems facing the UK. That matters, because as French puts it, big drops in input prices across the globe are “set to dwarf domestic factors” when it comes to inflation.
So what are those?
Global Price Pressures Are Easing
Long story short, the cost of “stuff” is dropping fast. Commodity prices have fallen. Energy prices are falling. Shipping costs are falling. Those factors will — for the year ahead certainly, and for longer, as far as Panmure Gordon is concerned — offset local issues such as wage bargaining and labour disputes.
On the more UK-specific side, British energy bills are more dependent on gas prices than in many places (because we’re more dependent on gas generation). The good news is that gas prices are coming down.
If that carries on, then it means, in turn, that the government’s expected bill for capping household and business energy rates will be lower than feared.
The clever bit — as French points out — is that the government can then use this “saved” (or rather, “unspent”) money to push consumer bills down further than currently expected (eg by keeping the cap per kilowatt hour where it is in April rather than raising it). In turn, that would bring down inflation faster, something which Chancellor Jeremy Hunt could then crow about.
The other UK-specific issue is the pound. Panmure’s forecasts are based on the sterling exchange rate staying roughly where it is. That’s sensible, but may end up being conservative. So it’s possible you’d get inflation coming down faster again if sterling strengthens.
In all, Panmure Gordon is now forecasting that inflation will go from 10.5% at the moment to 3.5% by the end of this year, and 2.5% in 2024.
That would be nice. That would certainly improve the general mood. It would give the Bank of England all the cover it needs to stop hiking at around 4.5% and to just sit there. And as long as employment doesn’t get crushed in the meantime, I would think this points to at worst a mild recession, and at best a “soft landing” with no recession at all.
What happens in the longer run though? In many ways, that’s what matters for investors more. The simple answer is: I’m not sure, but I have views, some of them stronger than others.
In the longer run, I personally have high conviction that interest rates will remain higher than they have in the recent past. I do not think that we will return to the “secular stagnation” period of ultralow interest rates and borderline chronic deflation. In other words, we’ll return to something more like “normality.”
This is a good thing. Asset prices will have to adjust somewhat, but that shift is already underway and with luck, it will be manageable.
Inflation itself is a trickier one to consider. As my view on interest rates implies, I think we’re past the constant flirting with deflation. But as to how long it takes to settle down, that’s an entirely different matter.
Maybe we’ll get back down to 2%, or even 3-4% quickly and smoothly. This tends to be the “sweet spot” for equities (which is why lots of equity fund managers will tell you that this is where inflation is heading, and that it’s no big deal).
That would be a scenario in which the “transitory” brigade were half-right. It implies that the biggest pressures on inflation came from the pandemic’s after-effects passing through the pipeline. Things would then largely go back to a higher, but pretty much stable, equilibrium.
This would be one of the better outcomes. History, however, suggests that this is a low probability scenario. Instead, in previous instances where inflation has risen as high as it has in the past year, it takes a long time to come down, and tends to be volatile for a prolonged period.
We’ll see. I lean towards the lessons of history but I’m not discounting the possibility that we’ll get lucky, and just quickly return to a period where inflation is higher than most of us are used to, but not disruptively so.
Author: John Stepek, Senior Reporter, Bloomberg
Managing Director, Head of Research