By Ben Lord, manager of the M&G Inflation Linked Bond Fund
This weekend Andrew Bailey once again took a clear opportunity to reiterate his previous suggestion that given rising inflation, the BoE would be forced to hike interest rates. Essentially, what has changed has been the energy markets. With natural gas and oil prices having soared in recent months, it appears likely that the energy price cap will again increase in early 2022, and this will likely result in inflation rising in the UK towards 5% in CPI terms (higher in RPI). This also lengthens the amount of time that inflation is forecast to be rising and elevated.
It appears that the BoE now wants to assert its inflation fighting and targeting credibility. It wasn’t that long ago that the BoE was de-emphasising the bond market’s ability to predict inflation. This was perhaps one of the reasons that the market has been increasing its inflation expectations, as it appeared that bond market concerns about inflation would not impact the path of policy. Well, bond market inflation breakevens have been on a strongly upward trajectory lately, rising from 3.4% in August to 4.1% today at the front end (5y), and up from 3.6% to 4% at the 10yr point. These are levels we have not seen since the distortions of the GFC, and clearly warrant some consideration.
What has been driving inflation’s rapid rise?
Early in 2021 we had the reopening, base effect driven bounce back in inflation numbers. These were well expected by markets and central bankers, and were well understood: if you had zero inflation or lower during lockdown in 2020, then there would considerably higher numbers in 2021 as economies unlocked. But there were always concerns from the bond market from a macro perspective that given the huge fiscal and monetary stimulus seen during the pandemic, inflation outcomes may turn out to be higher and longer lasting than expected. Supply shocks are now meeting demand shocks in many areas of the global economy, and prices are rising in aggregate at levels not seen for many years. But central bankers grabbed Jerome Powell’s ‘transitory’ mantra, and argued that these high inflation prints would soon pass. We are now in the period in which the market is having to grapple with the semantics around ‘transitory’, and in which central bankers are having to choose to defend or adjust theirs. In some ways, Bailey is using the energy and commodities price actions to argue that, now, high inflation is not transitory enough to be dismissed as transitory. Confused?
So given his clear discomfort with the level of inflation and the length of time it is expected to remain above target, Bailey wants to send a message that the BoE is serious about inflation targeting. So he now looks extremely likely to hike interest rates in 2021, and 2022, so as to bring it somewhat under control. This leaves us asking the following questions: 1. will interest rates hikes work in bringing inflation back down? 2. can the economy in its present state tolerate higher rates? And 3. Shouldn’t the impact of higher rates already be bringing inflation down?
- As mentioned, the primary justification from the change in policy stance recently from the BoE has been global energy and commodity markets. It is hard to argue that interest rate hikes by the central bank, of the UK in particular, will do anything to impact the global commodity markets, which appear to be reflected the meeting of supply disruptions with a strong global demand shock. It is easier to argue, though, that as a signal to markets, interest rate hikes will see bond market reaction of somewhat lower inflation expectations in the future. And with 10yr inflation expectations north of 4%, there is probably some merit in this. But that will not impact inflation outcomes, which appear set to be meaningfully above target for some time hence. Perhaps the view is that this will help avoid consumer inflation expectations starting to find themselves feeding into wage rounds, but the link between these two is complex. And on today’s information, it appears likely that inflation will be much closer to target towards the end of 2022 and in 2023. Could one, or should one, not argue that these inflationary forces are still transitory then?
- Rises in global commodity and energy prices already act as a significant dampener on economic growth and consumption, as more of disposable income is having to go to paying for these commodities. We all know the criticism that the ECB has come in for, time and again, as a result of its hiking into energy price shocks and the resulting second order damage those hikes have done to consumption and growth in the euro area. It is obvious that Bailey is risking coming in for the same criticism now. And what else is happening in the economy that might pretty strongly argue for monetary policy caution at this moment? The cutting of universal credit for one, with the backdrop of rising prices, suggests a perilous consumption outlook for many this winter and perhaps beyond. Higher borrowing costs on top of this surely will not help. The end of the furlough scheme now upon the economy also presents a clear argument for a more wait and see approach. Early indications are that the damage wrought by the end of this emergency policy has not yet been dramatic, but surely it is too soon to have a solid picture on this?
- Since August, as a result of global forces as well as the hawkish turn by the BoE, interest rates have already started to rise. Especially in the UK and especially at the front end. 2yr and 5yr gilt yields have risen by 60bps since the end of the Summer. This is already in the price of money. There has already been a tightening in borrowing costs, irrespective of a policy rate follow through. Given that inflation continues its upward path, shouldn’t this be clear enough evidence that a policy rate hike here and now is not going to bring about a fall in inflation?
My belief is that Bailey and the BoE have pre committed to beginning interest rate hikes in 2021 and 2022. And the reason now appears to be that they are nervous about inflation expectations both in the bond market (which they previously told us they were not bothered by) and in consumer expectations terms. My concerns though are that these will prove only partially effective in bringing down bond market expectations, because UK policy rates don’t affect energy or commodity prices, other than by a second order currency impact. I also think that whilst transitory was too vague to be given such elevated monetary policy status, one could still easily argue that much of today’s elevated inflation owes to temporary forces. And that given present downside forces on the UK economy and consumer, a hike now may be counterproductive in the longer term. Is the Unreliable Boyfriend about to worsen a winter of discontent?