Markets fear faster UK inflation as Brexit looms

Rise in inflation swaps has occurred at a time when those in other major economies have fallen markedly

UK asset markets have remained fairly calm in the face of political uncertainty surrounding Brexit. Sterling has weakened only slightly since the initial devaluation after the referendum in 2016. And UK equities have fallen 7 per cent this year, compared with a drop of 3 per cent in global equities (in local currencies).

So while there have been recent wobbles, there has been no crash in asset prices to rival the great British economic crises of past decades, such as the 1976 IMF crisis, the 1992 European Exchange Rate Mechanism meltdown or the 2008 financial crash.

However, there is one important exception: the market in future UK inflation rates (see box below). Without wishing to join the scaremongering of “Project Fear”, it is undeniable that this market has shown significant increases in concern about inflation risks.

This is how the three-year ahead UK inflation swap has moved since the referendum on EU membership in 2016, compared with the same inflation swaps in the US and the eurozone:

The equilibrium price for the UK inflation rate over the next three years jumped by a full percentage point in the months around the referendum in June 2016 as the market absorbed the inflationary impact of the 20 per cent devaluation in sterling. The inflation swap rate then fell slightly as a soft Brexit appeared probable in 2017, but it has risen by about 0.6 per cent since March 2018.

Although the rise in inflation swaps this year appears limited, it has occurred at a time when inflation swaps in other major economies have fallen markedly because oil prices have crashed. There has therefore been a sharp divergence between UK inflation markets and the global norm. For example, compared with the US, the forward UK inflation rate has risen by 0.8 per cent since last summer:

Why has the inflation picture in the UK worsened so dramatically compared with that in other countries in recent months?

The first point to note is that the rise in inflation swaps is greater than the increase in consensus economic forecasts for UK inflation over the same period. By definition, therefore, the change in the UK has been caused by an increase in the inflation risk premium, not by a change in the central expectation for UK inflation. The markets are becoming increasingly concerned about the tail risk of much higher inflation.

There may be several reasons why this tail risk has risen so much:

  1. Investors may be worried that a cliff-edge Brexit would trigger a further sterling devaluation, at a time when the UK labour market is extremely tight, and wage inflation is above the rate consistent with the 2 per cent inflation target. The combination of higher import prices and higher wages looks much more threatening than it did in 2016.
  2. UK inflation expectations are not as well anchored as they are in the US, the eurozone and Japan. In part, this is because there have been several episodes of a high inflation rate in Britain in the recent past. Another factor is that the Bank of England’s inflation credibility is not as well established as that in some other advanced economies. The Treasury can easily change the bank’s inflation target in a letter to its governor, without any need for complex amendments to legislation. In a severe recession, which the bank believes could follow a very hard Brexit, it is quite likely that politicians may raise the UK inflation target in order to force monetary policy to stabilise output for a “temporary” period.
  3. A hard Brexit could also cause problems for public borrowing and fiscal sustainability in the UK. Following repeated postponements in fiscal targets at any sign of an economic slowdown since 2010, the markets would expect the Treasury to tolerate much longer period of rising debt ratios in order to cushion a Brexit-related recession. A relaxation in fiscal discipline when confidence in sterling is already under strain could further undermine the authorities’ inflation credibility.

Conclusion

The UK’s constitutional crisis has not yet developed into an economic or financial crisis. But inflation risk is now rising, partly because the markets are increasingly concerned about a cliff-edge Brexit, and partly because the macroeconomic policy framework and the tight labour market are adding to the consequent risks.

The inflation market is the appropriate place to follow the market’s assessment of these combined risks. Market prices are very pessimistic, discounting a more disruptive outcome for Brexit and macro policy than at any time since the referendum.

This may eventually prove to be an overshoot, but it should be a serious concern for the bank’s Monetary Policy Committee when it gathers on Thursday for its final meeting of the year.

Markets in future UK inflation

There are two main ways in which investors can take positions that reflect the future rate of inflation in the UK.

In the gilts market, the difference between conventional bond yields and real yields in the index-linked market provides a measure of “break-even” inflation, measured by the retail price index. In the swaps market, investors can go directly “long” or “short” of RPI inflation rates, so the price that emerges in the market reflects the equilibrium that brings inflation optimists and pessimists into balance. Because of technical differences between these two markets, implied future inflation rates can differ, but they tend to move broadly together over time.

In both markets, the clearing price for inflation can be defined as the market’s central expectation for future inflation over the relevant period, plus or minus a risk premium. If the market price for inflation changes while consensus economic forecasts for inflation remain constant, then by definition the risk premium demanded by investors to clear the market has changed. This is what has happened recently.


Disclaimer

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 16 December 2018.
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