The UK’s Consumer Price Index (CPI) inflation rate accelerated to 2.5% y/y in June—a three-year high and above the Bank of England’s (BoE’s) target.[i] The release spurred many questions amongst financial commentators we follow, including: Are higher prices here to stay? How will the BoE respond? What will this do to UK debt, considering one-fourth of the debt outstanding is inflation-linked?[ii] In our view, these questions seem rather hasty. We think the faster inflation rate is likely to prove temporary—not the beginning of 1970s-style surging prices or the start of a debt spiral necessitating draconian spending cuts and tax hikes.
Whilst CPI’s June reading grabbed eyeballs, the acceleration wasn’t surprising to us. One reason why: a math quirk known as the base effect. Many statistics agencies report CPI on a year-over-year basis—i.e., the percentage difference between a given month and the same month a year prior—to smooth over short-term data volatility and show longer-term trends. But one-time events (e.g., last year’s COVID lockdowns) can cause major skew.
We have seen many experts recognise this calculation quirk, too. The ONS has noted lockdowns hurt demand for many goods, which affected certain CPI categories. As the agency described, “Spring 2020 saw crude oil prices fall to a 21-year low. At first this impacted producer prices, but it quickly fed through to lower petrol and diesel prices. Average petrol prices fell by 10.4 pence per litre between March and April 2020, the largest monthly fall since the current series began in 1990. As those negative contributions from last year’s falls drop out of the 12-month growth rate and are replaced by positive contributions from higher prices, this base effect can be expected to place upward pressures on headline inflation for the next few months.”[iii] The ONS anticipates these pandemic-related distortions to fall out of the year-over-year figures in a few months’ time—a sensible projection, to us.[iv]
Economic reopening also contributed to June’s higher inflation reading. Exploring month-over-month changes—which remove the base effect—shows this. June CPI rose 0.5% m/m, with categories including second-hand cars, clothing and footwear, eating and drinking out, and motor fuel the primary contributors.[v] Many of these categories have clear ties to economic reopening—e.g., prices for restaurant and café meals picked up between May and June as COVID restrictions eased. The transport category was the biggest contributor, adding 0.18 percentage point to headline CPI, due largely to second-hand cars and motor fuels.[vi] Whilst our research shows oil prices can be volatile month to month, higher second-hand car prices reflect a broader recent trend we have seen in America. It may be partly related to the global shortage of semiconductor chips used in new cars, which has weighed on auto production, prompting buyers to turn to the used car market.[vii] However, it seems unlikely to us that used-car prices keep rising at such a fast clip indefinitely, especially as producers address supply shortages.
Though inflation gauges may speed further in the coming months, we don’t think higher prices are here to stay. American economist Milton Friedman, a Nobel laureate, showed lasting inflation is a monetary phenomenon—excess money chasing a limited number of goods and services—a viewpoint we agree with. Whilst money supply may have increased by magnitudes, our research indicates it isn’t doing much chasing. M4 excluding intermediate other financial corporations (OFCs),a measure of broad money, has surged over the past year.[viii] Yet broad lending has slowed over the same time period—an indication that money isn’t making its way through the economy.[ix] Without money changing hands more quickly, we don’t think prices will rise for a sustained stretch. In our view, today’s higher prices are a passing phenomenon driven largely by economic reopening and isolated price pressures for goods in short supply now (e.g., semiconductors and raw materials such as lumber). As producers address supply shortages and the reopening pop fades, we think inflation will likely slow, too.
Similarly, we don’t think continually rising inflation is likely to cause debt service costs to spiral out of control. As many commentators have noted, 23.6% of the UK’s debt is in the form of index-linked gilts.[x] Their value is tied to the Retail Price Index (RPI, another measure of UK inflation). Index-linked gilts differ from conventional gilts in that interest payments and the principal payment at maturity are adjusted based on RPI movements. If the RPI rises, payments will rise correspondingly to account for the lost purchasing power—so if RPI rose quickly for long, that would likely make future debt service costs much more expensive than the Treasury initially projected. We have seen some experts worry major tax hikes and spending cuts would be necessary to fund these higher debt payments. The concern got even more attention this week after the government announced it spent a record £8.7 billion on debt interest in June—due in part to the rise in RPI, which raised the value of index-linked gilts.[xi]
However, we are sceptical about these projected scenarios. For one, more than 75% of the UK’s outstanding debt isn’t sensitive to near-term inflation rate moves. Note, too, that the average maturity of the UK’s debt portfolio is nearly 15 years.[xii] Therefore, inflation would need to climb and stay high for a long time before it starts impacting the debt’s affordability by raising the cost of traditional gilts across the board. Moreover, for all the attention paid to June’s record interest payment, we think it makes sense to consider the government’s ability to pay its obligations—which it does with tax receipts. Monthly debt interest payments can be volatile, so taking a longer-term view is sensible, in our view. In 2020, UK interest payments amounted to 5.9% of tax revenues.[xiii] Our research shows this isn’t necessarily an onerous level—it was higher in the late 1990s, which was a fine period for both the UK economy and shares.[xiv]
It is possible inflation speeds up and leads to higher-than-anticipated government financing costs. But we think it is more likely prices eventually slow as the reopening effect passes—rendering concerns about the negative fallout from higher prices a false fear. Consider: 10-year gilt yields have fallen in the past two months—from as high as 0.89% on 13 May to as low as 0.52% on 19 July—after the news of June’s faster inflation.[xv] We think that signals the gilt market, which is sensitive to investors’ inflation expectations, doesn’t envisage prices surging for the foreseeable future. In our experience, trusting what the market says generally serves investors best.
[i] “Consumer price inflation, UK: June 2021,” Staff, ONS, 14 July, 2021.
[ii] “Quarterly Review, January – March 2021, Debt Portfolio Overview,” United Kingdom Debt Management Office, 21 May, 2021.
[iii] “Beware Base Effects,” Grant Fitzner, ONS, 19 May, 2021.
[v] See note i.
[viii] Source: Bank of England, as of 23/7/2021. M4 excluding intermediate other financial corporations (OFCs), year-over-year percent change, May 2020 – May 2021.
[ix] Ibid. M4 lending excluding lending to intermediate OFCs, year-over-year percent change, May 2020 – May 2021.
[x] See note ii.
[xi] “UK borrowing leads to record interest payments,” Staff, BBC, 21 July, 2021.
[xii] See note ii.
[xiii] Source: ONS, as of 21/7/2021. Interest payments as a percentage of total revenue for 2020.
[xiv] Source: ONS and FactSet, as of 22/7/2021. Statement based on UK GDP, Q1 1998 – Q4 1999, and MSCI United Kingdom Index total returns in GBP, 1998 – 1999.
[xv] Source: FactSet, as of 21/7/2021. UK 10-year gilt yield on 13/5/2021 and 19/7/2021.
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