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December 13, 2022

A positive UK inflation surprise still leaves the BoE with a quandary

Two Macrobond users – both chief economists – break down the outlook in the UK and beyond.
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In-house blogger
Guest blogger
Jeremy Lawson
Economist at large
In-house blogger
Guest blogger
Shamik Dhar
Chief Economist
BNY Mellon Investment Management
All opinions expressed in this content are those of the contributor(s) and do not reflect the views of Macrobond Financial AB.
All written and electronic communication from Macrobond Financial AB is for information or marketing purposes and does not qualify as substantive research.

British inflation is starting to slow from a 41-year high – and more than analysts expected. Unfortunately, it was still at 10.7 percent in November (down from 11.1 percent in October), according to figures released today.

The Bank of England is predicting a deep British recession and inflation well over its 2 percent target into 2024. Meanwhile, the government plans a period of fiscal austerity. Will the central bank be forced to change course? Two Macrobond users share their reflections.

Countries that seem similar are experiencing very different inflation

Underlying inflation increased in every major advanced economy in 2022, and in every country besides Japan, central banks have reacted by tightening monetary policy. But despite those general trends, there have been important differences in how much the inflation environment has changed and how policymakers have responded.

For example, core inflation in Switzerland has increased less than in Japan, and to a lower level. Yet the SNB has lifted policy rates, while the BoJ has left yield curve control broadly unchanged. This partly reflects the fact that current core inflation in Japan is overstating “true” underlying inflation. But it also betrays what we think is a greater deflationary policy bias in Switzerland.

There is also an interesting contrast between Norway and Sweden. The latter has seen core inflation increase by more, and to a higher level. However, the Riksbank has increased its policy rate by less than the Norges Bank. Indeed, with Swedish core inflation amongst the highest of all the advanced economies, and real policy rates still too low, we think there is a greater risk of expectations becoming unanchored.

Finally, there are the UK and the US. Core inflation was already well above target in both countries at the start of the year, particularly in the US; essentially, the Fed was a long way behind the curve. But core inflation is now higher in the UK, and the BoE has lagged behind the Fed's tightening cycle. 

The BoE seems to still be relying on a lot of demand destruction to do the disinflationary job. We think they are underestimating the persistence of inflation, and will need to hike more than priced by the market to durably anchor expectations and bring inflation back down to target."

As forecasts from the BOE and the budget watchdog clash, what kind of growth environment awaits Jeremy Hunt’s fiscal restraint?

Britain’s finance minister, Jeremy Hunt, delivered his long-awaited Autumn Statement and the markets reacted much as he would have hoped – by doing very little. (That’s in sharp contrast to the market chaos of plunging gilts and sterling that followed the previous administration’s mini-budget two months earlier.) 

Hunt also managed to avoid over-tightening policy in the short run – our biggest concern after the Truss/Kwarteng debacle.  

The total fiscal consolidation amounts to GBP 55 billion (2 percent of gross domestic product) by 2027/28, but the bulk of that comes after two years when, presumably, the economy will be better placed to handle it. Policy is slightly looser over the next two years (by around a quarter percentage point of GDP). There is an even split between tax hikes and spending cuts, which is more (short-term) growth-friendly than if the budget had been focused on spending alone.

Arguably, fiscal rules have been loosened too. Public debt has to be falling as a share of GDP in the fifth year of a five-year rolling window (previously, the window was three years). The vow to balance the budget over three years is gone, replaced with a goal of running no more than a 3 percent total deficit over a five-year window.

These arguably give the Chancellor more wiggle room to cut taxes or raise spending in the next parliament. Nevertheless, this is a tightening equal to that of George Osborne in his 2010 austerity budget -- one that, in retrospect, many economists feel held back growth for some time.  

The key will be the growth backdrop for Hunt’s fiscal plans. That’s where it gets interesting, as the Office for Budget Responsibility and the Bank of England make different assumptions about growth, inflation and – by extension – monetary policy. 

The charts below show the difference, tracking consumer price inflation, nominal GDP and real GDP. Hunt will probably be hoping the OBR’s somewhat more bullish outlook comes to pass. 

The OBR forecast seems more sensible than the Bank of England’s, predicting a short, sharp contraction: a peak-to-trough fall in output of just over 2 percent, but spread over a shorter period of time – 5 quarters.  It could be even shorter than that, depending on what happens to energy prices.  

By conditioning its forecast on the market interest rate profile, and by saying the policy measures announced for the next two years reduce the output loss from 3 percent to 2 percent, the OBR may be subtly hinting that the Bank of England may need to raise rates further than it is currently signalling.  OBR growth forecasts further out look positively strong, averaging over 2 percent in the last three years of the forecast.  

Challenges remain, and we can’t be certain that the calm market will persist. The BOE still has to pull off quantitative tightening against a background where the global equilibrium real interest rate appears to be rising and the current account deficit remains large.  

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