Interview
Why the U.K.’s high inflation has global implications
- UK headline inflation stands at 8% with core inflation near 7%, significantly exceeding levels in the US and Euro area.
- The UK faces a unique "confluence of shocks" combining excess labor demand with major energy supply shocks, complicating disinflation.
- Recent inflation data surprised positively, driven by falling energy and core goods prices, though services inflation remains strong due to persistent wage growth.
- Goldman Sachs forecasts a slower disinflation process in the UK, with core inflation estimated to remain near 6% by year-end.
- The Bank of England (BoE) is expected to raise rates by 25 basis points this week, followed by two additional 25-basis-point hikes to reach a terminal rate of 5.75% in November.
- BoE policymakers are monitoring three criteria for inflation persistence: labor market activity, wage growth, and services inflation, with mixed signals reported for the upcoming vote.
- Markets are currently pricing in a 33 basis point hike, reflecting a roughly one-third probability of a 50 basis-point increase.
- UK gilt yields are projected to stabilize around 4.5% for the 10-year maturity in Q3 2024, with steady-state yields forecast at 4%.
- Unlike the 2022 liability-driven investment crisis, current gilt yield repricing is driven by fundamental inflation and growth dynamics rather than technical leverage, suggesting stickier rates.
- Household consumption has stagnated over the past year due to cost-of-living pressures but is expected to resume mild growth later in the year, supported by pandemic savings and declining headline inflation.
- UK real income is improving as headline inflation falls, contrasting with the US where household savings have largely been depleted.
- The economy is forecast to grow by 0.3% in 2023 and 0.7% in 2024, with a 40% probability of recession over the next year, double the risk in the US.
- Housing markets face significant headwinds as the effective mortgage rate is projected to rise from 3% to 4.5% by the end of 2024 due to refinancing pressures and shorter debt maturities.
- Post-Brexit immigration composition changes have reduced labor supply elasticity; while total immigration is higher, the decline in EU workers has led to overheating in specific sectors and higher wage growth.
- Fiscal policy is projected to shift from growth-supportive to a drag of 0.5% on GDP this year, increasing to over 1% in 2024 as higher interest payments constrain public finances.
- Sterling is expected to appreciate to $1.33 against the US dollar and €2.84 against the Euro over the next 12 months, supported by the BoE hiking longer than the Fed and ECB.
- Improving terms of trade from stabilized gas prices provide a fundamental tailwind for the UK currency, reversing the negative shock experienced in 2022.
- Quantitative tightening by the Bank of England currently incurs capital losses on sold assets due to higher interest rates, adding an additional fiscal cost.