Why the U.K.’s high inflation has global implications

Episode Summary

Executive Summary: The podcast examines why UK inflation remains unusually high versus peers, though recent data suggests disinflation has begun. Goldman Sachs economists argue the UK faces both demand-driven labor-market pressure and an energy shock, with wage growth and services inflation still sticky. They expect the Bank of England to keep hiking, gilt yields to stay elevated, sterling to firm modestly, and UK growth to remain weak but avoid recession in the base case.

Main Topics: Why UK inflation is unusually high (Priority: 5/5): Yari Steyn argues the UK is hit by a rare combination of shocks seen separately in the US and euro area: excess demand and tight labor markets plus an energy supply shock, compounded by weaker labor supply and post-Brexit immigration changes. Signs of disinflation, but services remain sticky (Priority: 5/5): Recent inflation data surprised to the downside, helped by falling energy prices and easing goods bottlenecks, but services inflation and wage growth remain strong, implying a slower path back toward target. Bank of England policy outlook (Priority: 5/5): The speakers assess the upcoming MPC meeting and conclude the BoE is likely to raise rates by 25 bps, then deliver two more 25 bp hikes to a 5.75% terminal rate by November. Market reaction: gilts and rates (Priority: 4/5): George Cole explains that markets are pricing a close call between 25 and 50 bps, with UK yields still elevated by historical standards and likely to remain sticky because this sell-off is driven by inflation rather than technical market dysfunction. Impact on consumers and housing (Priority: 4/5): Household spending has stagnated under the cost-of-living squeeze, but improving real incomes and leftover pandemic savings may support consumption later. Higher mortgage costs are still working through the system and will continue to weigh on housing. Sterling and global spillovers (Priority: 3/5): UK rate repricing has pressured global bond markets, but the effect is becoming more idiosyncratic. Cole sees room for sterling appreciation if BoE tightening lasts longer than the Fed/ECB cycle. Fiscal drag and recession risk (Priority: 4/5): Higher borrowing costs, inflation-linked debt costs, and quantitative tightening are turning fiscal policy from support to drag. Goldman Sachs sees low growth, but a base case of no recession, though recession risk remains material.

Key Arguments: The UK inflation problem is worse than peers because it combines both demand-side tight labor market pressures and the energy shock that hit Europe. Downside inflation surprises are encouraging, but the easing has come mainly from energy and goods; services inflation and wage growth remain too firm for a quick return to target. The Bank of England’s own inflation-persistence indicators—labor market activity, wage growth, and services inflation—are sending mixed signals, making a 25 bp hike the most likely outcome. Markets are pricing some probability of another 50 bp move because the BoE surprised hawkishly in June, but recent data has pulled rates expectations lower. Unlike the gilt turmoil of autumn 2022, the current move is fundamentally driven by inflation and growth, so higher yields are harder to reverse with a technical intervention. UK yields should stay relatively high because the BoE still has more work to do, and the 10-year gilt should be around 4.5% near the hiking peak. UK consumers have been hit hard, but falling inflation, strong wage growth, and residual pandemic savings should help consumption recover somewhat later in the year. Higher rates will feed through to mortgages slowly because UK borrowers are less floating-rate exposed than before, but the drag on housing is still not fully felt. Brexit altered immigration composition, reducing labor-market elasticity and making certain sectors more wage-pressured and prone to overheating. Sterling could strengthen if the BoE hikes longer than the Fed and ECB, while improved European gas prices should also support the pound. Fiscal policy is shifting from a growth support to a drag due to higher debt-service costs, inflation-linked debt, and QT losses on asset sales. The base case is no recession, but the UK has a materially higher recession risk than the US because of the combined shock mix and policy drag.

Data Points: UK headline inflation: 8% - Current level described as far above the US and euro area UK core inflation: around 7% - Current level discussed by Yari Steyn UK core inflation forecast: close to 6% by end-2023 - Expected disinflation path still leaves UK above peers Bank of England expected policy move: 25 basis points - Goldman Sachs baseline for the upcoming MPC meeting Additional expected hikes: Two more 25 bp hikes - Expected after the current meeting Terminal Bank Rate forecast: 5.75% - Goldman Sachs view for November Market pricing for meeting: Around 33 bps - Implied between a 25 bp and 50 bp hike Market-implied probability of 50 bp hike: About one-third - Derived from the roughly 33 bps pricing Current policy rate: 5% - Bank of England rate at time of recording Current gilt yield level: around 4.3% - 10-year gilt yield cited by George Cole Forecast 10-year gilt yield: 4.5% in Q3, 4.4% by end-2023 - Expected to remain near current levels Peak terminal market pricing: close to 6.5% - High point of market expectations before easing Current terminal market pricing: just under 6% - Market pricing at time of discussion Effective mortgage rate: from 2% to 3% so far - Average household mortgage cost rise already felt Effective mortgage rate forecast: 4.5% by end-2024 - More mortgage drag still to come UK consumption growth: basically sideways over the last year - Consumer spending stagnation amid inflation shock UK GDP growth forecast: 0.3% in 2023 - Goldman Sachs growth estimate UK GDP growth forecast: 0.7% in 2024 - Goldman Sachs growth estimate Fiscal drag on growth: -0.5 percentage point in 2023 - Estimated fiscal policy subtraction from growth Fiscal drag on growth: more than -1 percentage point in 2024 - Expected larger fiscal headwind next year Recession probability: 40% over the next year - Goldman Sachs estimate for UK recession risk US recession probability comparison: about half of UK risk - UK risk said to be about twice the US level Sterling forecast vs USD: 1.33 in 12 months - Goldman Sachs FX view Sterling forecast vs EUR: 0.84 EUR/GBP - Expected appreciation against the euro

Pivotal Quotes: "the UK faces a real confluence of shocks that we've seen in other regions" — Yari Steyn: Explaining why UK inflation has been more severe than in the US or euro area "we think that's going to tip the balance towards 25 basis points this week" — Yari Steyn: Forecasting the Bank of England's likely near-term decision "this time around, the repricing is going to be stickier. It's going to be more long-lasting" — George Cole: Contrasting the current gilt sell-off with the 2022 LDI crisis

Implications: UK inflation is probably past its peak, but it is not yet solved. Expect higher-for-longer rates, persistent pressure on mortgages and fiscal accounts, modest sterling support, and only a slow consumer recovery.