At first blush, it may feel strange to be discussing inflation risk in the United Kingdom in the current environment.
However, given the unprecedented response to the current crisis from Governments and Central Banks globally, the impact of this activity on inflation and the consequences for financial markets now requires examination.
Where are we now?
Current UK Consumer Price Inflation (CPI) is at 0.7% for Feb 2021. The Bank of England’s forecasts are for a relatively sharp rise towards 2% in the first half of 2021 and to maintain a level close to its target of 2% for the next 3 years.
Two elements of the debate have changed in the last few months. Firstly, greater acceptance that inflation will increase and a range of forecasts that are increasingly coalescing around the 2% level. This is driven by a mechanical increase from Spring 2020 and a significant increase in spending by recently vaccinated consumers. Secondly, there is a growing body of opinion that the risks to inflation numbers are on the upside, which contrasts with lower than expected outcomes over the last few years.
We are not an island
Inflation expectations in other parts of the world have increased significantly. The IMF now projects 6% global growth in 2021 and 4.4% in 2022. When this is combined with extraordinary spending plans, notably in the United States, there is increasing risk of importing inflation from other parts of the world as rising bond yields in one part of the world will impact the relative value of the UK markets.
How will interest rates react to this increase?
Even if inflation numbers exceed formal targets of 2% in the short term, we expect Central Banks around the world, including in the UK, to “look through” this rise in 2021 and classify any increase as “transitory” as we emerge from COVID restrictions. We do not expect this to affect short term interest rates in the next 12 months. We do, however, believe this may affect longer term interest rates and the recent rise in yields in the Gilt market may come to be seen as the start of this paradigm.
Are Central Banks correct to “look through”?
In the short term, yes. Central Banks may and should be comfortable to run above target inflation for a while for socio-economic reasons. However, the impact of massive monetary and fiscal stimulus cannot be ignored forever and will eventually drive higher inflation.
Why does any increase in inflation matter so much to financial markets?
There are 3 key reasons why this is so fundamental:
1. The UK economy is vulnerable to an increase in higher interest rates given the increase in public debt due to the current crisis. The OBR recently quantified this as a 1% increase in interest rates leading to an increase in debt interest payments by more than £20 bn in the coming years.
2. The equity markets in the UK have evolved in a low inflationary environment and much of the long-term growth in share prices over the last 30-40 years can be correlated to the start of the declines in inflation from the early 1980s.
3. Complacency risk. Financial markets have taken inflation for granted as a following wind for many years. The last 30 years have seen a steady reduction in inflation and any change to this central case of long-term low inflation would have a profound effect on both asset allocation and overall equity indices.
In conclusion, the world has received a “shot across the bow”. There is little, short-term concern around inflation. However, a combination of the pressure from government and Central Bank activity has already manifested itself in increasing bond yields and breakeven rates in the US and the UK. We have been warned and need to keep a close eye on this story in the coming months and years.
Find out more
If you would like to discuss any aspect of this ‘Insight’ in more detail then please get in touch with us at firstname.lastname@example.org.