In our last piece, we focussed our discussion on the UK and the Bank of England, following their larger than expected 50bp hike, taking the Bank Rate to 5.00%. The BoE, chastened by a string of data suggesting inflation ‘persistence’ - highlighted in the May ‘forward guidance’ as being the most policy sensitive factor - voted 7 - 2 for 50bps. The now familiar dissent of Swati Dhingra and (the soon to be replaced) Silvana Tenreyro held firm for unchanged and have subsequently expounded their rationale - that there are encouraging signs from trends in producer prices and that there is significant tightening yet to come through from the lagged effects of cumulative past rate hikes - arguments that we made last week.

Furthermore, last week we highlighted that while the 50bp increment was larger than expected, the recent strength in inflation (and most recent wage data) had shifted the balance of expectations to include the prospect of a larger policy increment and that if the BoE came to the conclusion that with market expectations rising and the prospect of having to extend the hiking cycle beyond the June meeting the BoE may have seen merit, in a bigger increment to ‘get ahead’ of the building price pressures. The emphasis that the decision applied only to “this particular meeting” may be indicative of this thinking and possibly stated to avoid markets extrapolating the 50bp move to future policy decisions - though some very notable analysts have already done so. At this week’s ECB’s Forum on Central Banking from Sintra, Governor Bailey suggested that this was indeed the case - that they saw little point in hiking 25bps now with the intention of doing so again in July, rather than just doing 50bps now!

So where does this leave us in terms of the inflation trajectory (in the UK and across DM) and thus the central bank reaction function?

Over recent weeks, there has been a clear resurgence of concern over ‘sticky’ inflation, and by extension, market concern that the end of the hiking cycle in DM may not be as close as some had hoped. However, there have also been some more encouraging signs. In Canada, where, after a lengthy pause, the BoC appear to have been spooked into renewed hikes by an inflation jump and some better-than-expected growth data, this week’s inflation data showed a sharper than expected drop in core prices, with headline inflation back to just 3.4% y/y. In Australia, the May inflation data surprised sharply to the downside (5.6% y/y from 6.8% y/y, against an expected drop to 6.1%), bringing into doubt the prospect of a further 25bp hike from the RBA next week. In the UK, declining consumer credit and clearer signs of falling house price add to the (Dhingra/Tenreyro) argument for a more cautious approach to UK rates.

We have a couple more thoughts on the trajectory and inference of the current inflation dynamic. Thoughts with specific reference to the UK, but with implications globally.

Firstly, we see distortions over the ‘basket of goods’. The basket, or the goods and services that collectively form the underlying basis of the inflation calculation, are likely distorted. The suggestion is that there is a significant amount of substitution of goods (anecdotal evidence from supermarkets shows a 40% rise in demand for value brands) or foregoing of goods in order to enjoy services or due to the squeeze on consumption directly from higher prices. Thus, if large numbers of consumers have switched or foregone items in the ‘basket’ calculation, then the ‘basket’ that informs the CPI numbers may well be significantly overstating underlying demand - and thus the need for tighter monetary policy. In the UK, we are of the view that there could well be some of this consumer substitution that is distorting the ‘true’ inflation rate.

During the recent small bank shock in the US, Governor of the Bank of England highlighted the recent sharp changes in the ability of consumers to communicate and activate bank transfers (through modern technology) and thus the risks to bank deposits under unfavourable scenarios. The ability of the consumer to search and purchase cheaper items electronically may well be viewed retrospectively as rendering the CPI basket (updated as we understand it every 1-2 years) as outdated or at least excessively discrete.

Secondly, we are of the view that there remains significant price distortion from the energy price shock. In the UK, there was much focus placed on the government energy price cap - something we discussed at the time as a huge (and ultimately very successful) short position in natural gas from the (brief) Liz Truss government. The cap, while likely limiting the extent to which headline inflation rose in the first instance is also likely a significant contributor to the slower than expected decline. However, energy price caps only ever applied to households; businesses had to negotiate directly with energy providers. The result was a wave of very big jumps in underlying costs to manufacturing and service sectors that forced prices higher by default. Depending on the length and timing at which agreements fixed, it is likely that between now and the end of the year, the company energy price bills will fall dramatically - enabling more price competition between domestic goods producers and most notably services.

Ultimately, we continue to see the distortions to consumer prices to be significant, both in terms of their composition and drivers and in terms of their measurement and implications for underlying demand - the target of monetary policy. As this week drew to a close, MPC member Sylvana Tenreyro stated her view that “the more the BoE raises rates now, the faster it must cut” - sentiment we would completely agree with.

Central bankers globally have continued to convey the narrative of holding rates steady in restrictive territory, However, we see little ability of DM central banks to do so, having gone so far against what we see as some important macro (and micro) developments and anomalies. In the UK, this week saw nationwide house prices in negative territory for a fourth consecutive month. We have highlighted this on many occasions and firmly believe that the housing market is key to the non-linearity of consumer demand (particularly in the UK, due to its idiosyncratic composition, but also more globally). In our view, the Fed is still behind the inflation curve, and will need to cut rates by a significant amount in the coming quarters.

After, the financial crisis in 2008 in the US, the NBER backdated the start of the recession by around six months. Given the size of the shocks that we have seen on the demand and supply side as a function of the pandemic, it is not out of context to suggest that the economic growth backdrop (especially in the UK at the current juncture) is weaker than the current data suggest – nor that DM central banks are behind the curve on inflation. Indeed, to paraphrase the great David Bowiein terms of the turn in global central bank hawkish sentiment “the time is near, there’s not too long”.