UK Faces Nightmare Dilemma With Inflation Gauge At 25-Year High

Never miss an opportunity to use the word “century” in a headline.

That’s especially applicable to financial media. If there’s an inflation tie-in, that’s even better. I eschewed the temptation to employ “quarter-century.” I’m not one for bombast unless it’s tongue-in-cheek. I went with “nightmare” instead.

10-year breakevens in the UK touched 4.25% Friday, the highest since 1996 (figure below). For context, it wasn’t until 1997 that the BOE gained operational independence to pursue price stability.

The most recent global bond selloff began in earnest on September 23, when the BOE statement skewed overtly hawkish just hours after the Norges Bank became the first central bank to raise rates in the pandemic era among countries with the 10 most-traded currencies.

Earlier this week, a dramatic bout of bear flattening in gilts (precipitated by Andrew Bailey’s “we will have to act” remarks) suggested traders are now convinced that central banks have run out of patience when it comes to countenancing inflation overshoots. Markets priced in 15bps of tightening from the BOE in November and more than 30bps by year-end.

Some former policymakers think the market may be ahead of itself. For example, Bloomberg on Friday cited Andrew Sentance, David Miles and John Gieve, MPC members who served during and after the financial crisis, in suggesting the bank “will likely defy investors’ expectations of a sudden interest-rate increase next month because it rarely shifts policy in such dramatic fashion.”

At the same time, chief economist Huw Pill told FT that next month’s meeting is “finely balanced.” Although Pill characterized inflation as “transitory” and emphasized that in the BOE’s base case, the bank doesn’t see “a need to go to a restrictive stance,” he also warned inflation could hit 5%.

Note that the BOE faces the same dilemma as the Fed — namely, they risk choking off the recovery in a bid to tamp down price pressures. Retail sales fell 0.2% in September, data out Friday showed (figure below). The market expected a 0.6% gain.

It was the fifth consecutive monthly decline, the longest streak ever.

Plainly, that suggests economic momentum is waning. Distortions are rampant. “The drop last month is all the more surprising because of panic buying of fuel during a supply crisis,” Bloomberg wrote. Fuel sales jumped nearly 3%, exceeding pre-COVID levels. “That boosted sales at some filling stations, but depressed them at others that lacked supplies,” the same linked article said, summarizing.

The UK is on the frontlines of the energy crisis and is also battling a new COVID wave tied to a mutated version of the Delta variant. Cases are rising (figure below).

This week, The British Medical Association suggested the government is “willfully negligent.” “The Government has taken its foot off the brake, giving the impression that the pandemic is behind us and that life has returned to normal,” the BMA said, in a scathing statement. “The reality today is an unacceptable rate of infections, hospitalizations and deaths, unheard of in similar European nations. In comparison to France, we have more than 10 times the number of cases and almost four times as many deaths per million.”

Good luck sorting all of this out. This is a veritable nightmare for policymakers of all sorts.

I suppose the BOE can fall back on price stability and put the harder decisions off on the government. But aggressive rate hikes seem at least as risky as standing down and chancing an inflation spiral. If consumers retrench and the country is forced back into some manner of limited, modified lockdown, tighter monetary policy could be a noose. Especially considering rate hikes won’t solve some of the most vexing issues pushing up prices.

Pick your poison.