Peak, pivots and pauses, as core inflation persists

Oil prices have risen significantly in recent weeks. This is a double whammy for Western economies like the UK. It squeezes spending power and adds to costs at a time when growth is sluggish, and it pushes inflation up again, perhaps temporarily. Already the recent rise in oil prices has contributed to the markets expecting an increase in the annual rate of inflation in the next monthly data (due on September 20th) because of higher fuel prices.

Even allowing for a rise in the August data, the trend is for headline inflation to decelerate further. In the UK it has fallen from 11.1% last October to 6.8% in the latest official figures for July. From a domestic political perspective, attention will be on whether inflation halves by year-end compared with a year earlier, which it might, in line with the government’s aims.


Yet from an economic perspective, the focus is likely to be on whether headline inflation will decelerate significantly further next year. It could even undershoot its 2% target, before subsequently settling at a higher rate.


However, core inflation is stubborn. Core inflation takes out the volatile items, but the measure of core can vary across countries. For instance, the US Bureau of Labor Statistics excludes food and energy in its measure of core, while the UK’s Office for National Statistics (ONS) reports core as excluding energy, food, alcohol and tobacco, namely items that are volatile or impacted by tax changes. 


Indeed, in August, the UK's new alcohol duties led to rises in the prices of wine, spirits and some beers. To avoid the duties some beers will have been weakened in strength (a version of ‘shrinkflation’ where even if the price has not risen, quality has been reduced, so you are effectively paying the same for less). Meanwhile, the RAC Fuel Watch reported that in August petrol prices rose 6.68p a litre to 152.25p for unleaded, and by 8.01p for diesel to 154.37p, making for the fifth and sixth biggest monthly rises in 23 years.


Because energy prices had risen sharply last year after the war in Ukraine started, favourable base effects have been contributing to falling annual inflation, but if firmer oil prices persist then this can no longer be expected to be the case. The first-round drivers of inflation have been reversed, namely supply-side shocks from the pandemic or war, and previously excessively lax monetary policy.


The focus now is on the second-round drivers of inflation, including higher wages (although the reality is wages have been playing catch-up and were not driving inflation), and as firms pass on higher costs to maintain or even increase their margins, with a majority of items rising in price in the latest inflation data.


Higher oil prices globally are not reflecting a stronger global economy but largely a deliberate tightening of supply by Saudi Arabia and Russia. This is reflective of the geopolitical shift to a G3 world (US and allies, China and partners, and the non-aligned countries) I have highlighted previously, and which was also seen in the diverging approach taken on key issues at the recent G20 Summit in India.


In some respects, this idea of core can be misleading when it comes to inflation, as higher energy prices will impact the whole economy, pushing up costs in all areas. But it is the stubbornness of core inflation that is the headache for central banks. In the euro area, for instance, core inflation (excluding food and energy) has been above 5% since last October, while headline inflation decelerated. Now both are the same, at 5.3%.


In the US, the Federal Reserve’s preferred measure of inflation, the PCE deflator has decelerated from 4.3% in April to 3.3% in July, but the core measure has moved from 4.6% to 4.2% over the same period. The latest consumer price figures for August showed a large monthly rise in the headline rate of 0.6%, to 3.7% year on year while core (excluding food and energy) rose 0.3% on the month but are up 4.3% on the year.


Meanwhile, in July, the ONS measure showed core inflation of 6.9% was above the headline rate of 6.8%. While the annual rate of goods price inflation eased from 8.5% in June to 6.1% in July, the annual rate of service sector inflation rose from 7.2% to 7.4%


How, then, will the Monetary Policy Committee (MPC) of the Bank of England vote on interest rates on 21st September? Recent comments from the Governor were reported widely as suggesting rates could stay on hold. However, he made similar comments in the spring and rates have risen since. The Bank’s guidance would have taken you the wrong way before in predicting rates.


Nonetheless, dovish recent comments from three of the nine person MPC contrast with recent hawkish comments from only one. That would suggest a change is possible, away from further hikes to a pause, or even a peak. The MPC has had a bias to tighten for some time now, giving the impression of more to come, as it responded to data or to market pressure. 


What remains remarkable is how coincident monetary policy actions have become. Even though monetary policy is widely thought of as acting with a long and variable lag, of twelve months or more, it is the latest economic releases that dominate the policy debate and often the actions taken. With policy rates having risen from 0.1% to 5.25% there is considerable monetary policy tightening in the pipeline that is yet to feed through fully. Furthermore, bond yields have also been driven higher by the Bank’s move towards quantitative tightening, and this is set to continue even when policy rates have peaked.


The monthly GDP figures show an erratic trend recently, impacted by an extra bank holiday in May, a rebound in June and dented by strikes in July. So far this year, the monthly GDP figures are up 0.4% in January and 0.1% in February, down 0.2% in March, up 0.2% in April, down 0.1% in May, up 0.5% in June and down 0.5% in July. This erratic trend is consistent with offsetting characteristics of a sluggish economy that lacks momentum but also one that is proving resilient and avoiding recession. The latter has also been seen in the jobs data, although there is now tentative evidence the labour market is softening.


ONS data shows that in the three months from May to July, employment fell 207,000 versus the previous three months, with the employment rate (for 16-64 year olds) at 75.5%, down 0.5% on the previous quarter. Also, unemployment rose by 0.5% over the same quarter, to its current 4.3% which is also 0.3% higher than pre-pandemic. Vacancies, at 989,000 in July to August are still high, being 188,000 above pre-pandemic figures, but have been falling since the middle of last year. Wages, meanwhile, are rising in the three months to July at an annual rate of 7.8% and at 8.5% including bonuses.


For the MPC to contemplate pausing or calling an end to their hikes, they will likely need to be convinced by evidence of a softening in the labour market or that core inflation is easing. They could then tie their decision to such information. The market thinks UK rates are yet to peak. A 0.25% hike at the next meeting to 5.5% with a signal then that it is the peak would not be a surprise, and is probably the most likely outcome, but communication from the Bank has been so poor that the markets are wary of guidance.


For a few months I have been expecting rates to rise but have suggested it made more sense to pause and see how previous tightening feeds through and how the economy copes. Monetary conditions are now tough. For instance, the effective interest rate on new loans to small and medium-sized enterprises (SMEs) reached 7.19% in July, compared with 2.51% in December 2021, while lending to non-financial SMEs remains depressed, falling by an annual rate of 4.2% in July.


Despite the economy’s resilience to date, downside economic risks are evident. Yet, there is certainly no case to ease or to contemplate pivoting given the uncertainty about underlying inflation. As I have noted before, when the inflation environment shifts, the market is often slow to recognise this.


Of course, the higher rates go the greater the risk of over-tightening which would then trigger market expectations of a pivot next year. This is already the market conjecture in the US. Interestingly, in the UK the fiscal stance is tough, unlike the US where fiscal policy is still stimulative. But to repeat a previous message, even when inflation decelerates in the UK it is likely that inflation will settle eventually at a higher level, perhaps 3%, rather than the 2% previously.


The policy challenge at that time will be that it is necessary to avoid a return to cheap money, with policy rates settling above inflation and thus pointing to a period of positive real interest rates. For now, the focus is on when rates will peak, but it is also important to factor in a very different future rate environment compared with the recent past.



Please note, the value of your investments can go down as well as up.


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