The Bank of England's inflation forecast was wide of the mark
Earlier this week, inflation in the UK exceeded projections and gilt markets sold off sharply. The Bank of England forecast that inflation would fall from 10.1% in March to 8.4% in April, but they missed the target and inflation only fell to 8.7%. Most of the decline was due to a widely expected adjustment in energy prices, but other components such as food and retail remained stubbornly high.
The self-off in the gilt market that was triggered by this inflation print means that gilts are now priced similar to how they looked after Liz Truss’s disastrous mini-budget, in which the Government announced a raft of tax cuts. These tax cuts spooked markets, which quickly dumped gilts. This in turn caused turmoil in the pension and sterling markets.
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The sell-off this week has been nowhere near as sharp as what happened after the Truss mini-budget. But it means that the UK has higher borrowing costs than most European countries. The interest rate of a 10-year UK Government bond is around 4.4% — much higher than Germany (2.5%) and France (3%), and only really comparable to Italy (4.3%) which has long been seen as one of the riskiest borrowers in Europe.
The main cause of this is the higher relative inflation rate in Britain when compared with Europe. The EU average inflation rate in April clocked in at around 8.1% against Britain’s 8.7%. Some are quick to blame this on Brexit, but, really, it is due to wage pressures in the UK. A wave of strikes — cheered on by the same people blaming Brexit for the inflation — has ensured that a wage-price spiral has taken hold in Britain. This spiral occurs when workers refuse to take the hit on living standards caused by inflation and demand higher wages, but the higher wages are just passed on to consumers in the form of even higher prices.
But focusing on the wage-price spiral ignores the bigger picture. The British economy is simply not well placed to deal with inflation and instability. Manufacturing in Britain has fallen from making up around 20% of GDP in the early-1980s to less than 10% today. Britain plugs the gap with services, mainly financial services in the City of London. But because this is essentially shuffling paper, the British economy runs a persistent trade deficit. Since 2000 the country has had a trade deficit of anywhere between -2% to -6% of GDP.
This is a highly unstable economic model. If the markets ever decide to dump the City, sterling will fall in value precipitously, and the trade deficit will be forced to close by a large contraction in domestic consumption. That means a significant decline in living standards for the average Briton, making the current wage-price spiral and the action in the gilts market even more concerning. It is no wonder that the Bank of England seems intent on getting the situation under control, signalling that more rate hikes are almost definitely in the pipeline. More rate hikes, however, likely mean a recession in the near future.