The Bank of England (BoE) should be commended on their efforts to to avoid the debt deflation trap. In the aftermath of the Lehman Brothers collapse, the 4.5% cumulative reduction in the BoE Bank rate and the £200bn quantitative easing programme were critical elements in stabilising the U.K. economy and generating the conditions necessary for inflation expectations to remain positive. That in turn resulted in credit creation and moderate positive economic activity. However, with such success come challenges, now in the form of persistently high inflation and what follows is a string of inevitable questions: Is U.K. inflation really going to get back to its target level of 2% or is the BoE overly optimistic given the degree of underlying price pressures? If so, should they do anything about it?
Since Lehman’s collapse in September 2008, U.K. headline consumer prices inflation has averaged 3%. Now that figure is 4.5% and looks set to climb higher in the months ahead. While much of the recent rise is due to the well documented combination of value added tax (VAT) hikes, sterling weakness and surge in commodity prices, even by the BoE’s own admission, the Consumer Price Index (CPI) is unlikely to get back to the 2% target by the first quarter of 2013, and it’s difficult to disagree with that sentiment.
Mervyn King, the governor of the BoE, has made his views clear: To generate the conditions necessary to bring inflation down more aggressively would put even greater pressure on U.K. households, more indeed than seems reasonable (see King, 25 January 2011, Speech at the Civic Centre, Newcastle). But that does not mean that investors should not be aware of where CPI is likely to settle down, especially for those investing in the U.K. financial markets and the bond market in particular. For example, ten-year gilt yields are currently at 3.3%, which means U.K. inflation really needs to fall back to the 2% level if investors expect to generate any sort of post inflation return. Sadly, that does not look likely.
To understand why U.K. CPI inflation will likely remain sticky we should look at past U.K. inflation drivers and ask whether these conditions remain in place for the future. Alongside the BoE, our own “top-down” models suggest that inflation should fall comfortably below 2% in the years ahead. Unfortunately, those same models suggest that outside of the VAT effect, CPI should already be below 2% rather than at the current inflation rate of 3% (Figure 1)!
So if the top-down approach is already creating puzzling forecasts for the level of U.K. CPI, what happens if we try and identify where the glitches might be?
Goods and Service Sector Inflation
One way to approach the underlying inflation dynamics is to split the CPI into its two core components of non-energy goods prices and service sector prices. These components comprise 33% and 45% of the headline CPI, respectively.The remaining 22% of the index is split between food and energy prices in roughly equal measures.
Historically, U.K. non-energy goods prices have been closely correlated with prior moves in the sterling trade-weighted index (Figure 2). This is alongside the fact that for much of the decade before 2008, non-energy goods prices were negative due to the beneficial effects of goods price deflation exported out of emerging markets. These were the key reasons behind the low and stable inflation enjoyed in the decade leading up to 2008. Headline CPI averaged 1.6%, largely due to non-energy goods prices falling by an average of 2% per annum whilst service sector prices rose by an average of 3.7% per annum.
However, we are now in a period where emerging markets are unlikely to export more price deflation and sterling has remained stable for two and a half years. From our analysis, we believe that the effect of the 2008 sterling depreciation has already worked its way through the CPI, so while goods prices are not rising to the 2-3% level seen over 2009/10, neither are they falling by 2% per annum. Indeed, it looks very likely we will see goods price inflation remain broadly flat to modestly positive rather than negative.That of course does not mean that the sizeable output gap is not having an effect on goods prices. Rather, global goods price deflation does not create an additional “tailwind” any more.
So what about the service sector? Given that the service sector tends to be more domestically focused, we should see the effect of the output gap more clearly here, and to some degree we are. However, the degree of the service sector disinflation looks to be falling. Low wages may indeed help to bear down on service sector CPI but as we have seen from recent years, this has really only taken service sector price inflation down towards 3% rather than anything more substantial. Indeed, based on our analysis of the relationship between service sector wages, service sector activity and service sector CPI, it looks like we may well have reached the cyclical low point for service sector inflation (Figure 3).
Pulling it All Together
The components of the CPI that most broadly fall under the control of the Monetary Policy Committee (MPC) do not as yet imply a worrying degree of inflation risk in the U.K. However, neither are they as subdued as historical top-down analysis would suggest. When we disaggregate core CPI into goods sector inflation and service sector inflation, we can see that the underlying dynamics of weak growth and a substantial output gap have been holding down price pressures, but these have been largely offset by the fading deflationary impulse from the emerging markets. As a result, core CPI is no lower than it was during the “NICE” decade - non-inflationary consistently expansionary - prior to 2008.
With core CPI unlikely to generate much further substantial weakness, this suggests that U.K. CPI will continue to be buffeted by food and energy inflation. With food and energy inflation largely determined by the strength of global growth, and in particular sustained emerging market growth over the next three to five years, U.K. CPI will likely struggle to fall back towards the 2% target any time soon. Core CPI could well stay at current levels of 1.5% - 2% but when we add in the more volatile commodity component this suggests that the BoE may continue to have a job explaining why CPI is higher than expected. That’s not to say U.K. CPI is about to lift off, but that the rediscovered art of letter writing may remain a key component of the U.K. monetary framework (the governor, on behalf of the BoE and MPC, is required to write an open letter to the Chancellor for every three consecutive months the CPI deviates by more than 1% from its 2% target).
So does that mean the MPC should change tack and hike rates aggressively to demonstrate its inflation credentials? No – overshoots of the inflation target may now be commonplace but, as the governor has already explained, the marginal cost in terms of lost employment will likely comfortably exceed the marginal benefit of enhanced inflation credibility. As such, the BoE is right to be cautious on raising the Bank rate given the current state of the economy. What does all this mean for U.K. asset valuations? One of the key themes to come out of our recent Secular Forum revolves around the willingness to repair levered sovereign balance sheets via a combination of low interest rates and higher-than-anticipated inflation. History has shown this to be a powerful tool, and the post WWII fiscal retrenchment and the current policy framework seem to exhibit many of the same characteristics.
With spot CPI at 4.5%, short rates at 0.5% and the BoE still holding £200 billion in gilts, the tolerance for higher-than- anticipated inflation seems clear enough. This may be a good policy framework for dealing with high levels of nominal debt, but as a bond investor faced with 10- or 30-year gilts yielding 3.3% and 4.2%, respectively, this does not seem like an opportune time to lock into those yields. What’s good for the government and the economy isn’t necessarily good for investors. We believe investors should look to other assets and “safe spread” sectors where you are adequately compensated for inflation risk. PIMCO defines “safe spread” as sectors that are most likely to withstand the vicissitudes of a wide range of possible economic scenarios.
This speaks to intermediate U.K. index-linked bonds alongside shorter maturity higher yielding assets within the U.K. or indeed beyond the U.K., namely emerging markets where real yields are positive. Opportunities still exist – you just have to look a little harder to find them.