Comments from Mike Riddell, Head of Macro Unconstrained at Allianz Global Investors.
Key takeaways:
- Whilst headline inflation is flat vs last month, core inflation has accelerated even further. This leaves the Bank of England (BoE) with little choice other than to continue hiking rates, to weaken demand
- It seems very unlikely to that the BoE would deliberately run monetary policy too loose
- If problems on the supply side do not improve, then the BoE will be forced to further reduce demand to get wage growth lower. If it doesn’t, then the BoE may as well not have an inflation target
The latest UK inflation data illustrates that headline inflation is flat vs last month, however, it was expected to fall based on year-on-year commodity base effects. Crucially, core inflation has accelerated even further. This leaves the BoE with little choice other than to continue hiking rates, to weaken demand.
If the Bank of England is reluctant to hike rates sufficiently, then this could result in an unanchoring of longer-term inflation expectations. This would be hugely dangerous and could at worst, lead to the BoE losing credibility, inflation moving higher, real interest rates moving lower, overseas investors (who the UK economy is still partly reliant on) losing confidence in the UK and sterling collapsing, which causes inflation to jump higher, and so on.
It seems very unlikely to that the BoE would deliberately run monetary policy too loose. In the unlikely event that headline inflation is still very sticky at the beginning of next year, then it is possible that the BoE would continue hiking in 2024 too, where the BoE could take rates to 7% if it proved necessary. This would be very damaging to the UK economy, but that is the difficult decision that the BoE faces. If long term productivity growth in the UK is now only around 1% – as per the BoE’s estimate – then it implies that when the economy is at full employment, wage growth above 3% will likely be inflationary. If problems on the supply side do not improve, then the BoE will be forced to further reduce demand in order to get wage growth lower. If it doesn’t, then the BoE may as well not have an inflation target. We believe that the BoE will respond by continuing to hike rates aggressively, which will ultimately succeed in pushing inflation much lower, and which will also substantially weaken UK economic growth.
We therefore think that gilts and index-linked gilts are now offering decent value, and in the last week have positioned our funds to benefit from gilt yields to start falling. Inflation linked gilts are implying that the BoE base rate will remain well above inflation for the next decade. Conventional gilts similarly look very attractive, unless inflation remains well above what the inflation market is already pricing in.
