Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is senior vice-president and economist at Pimco
Rewind a few months and some people feared the UK was a global outlier. Core inflation was running at close to 7 per cent in May in year-on-year terms — almost 2 percentage points above that in the euro area and the US at that point.
Worse, underlying price pressures appeared to be accelerating, while activity remained depressed, with GDP still below its pre-pandemic level and underperforming the post-pandemic recovery in almost all other developed countries.
At face value, the UK seemed to suffer from structurally higher inflation. Many blamed Brexit or other supply shocks, including a fall in labour participation, while others pointed to a lack of monetary policy credibility. At one stage, in early July, financial markets expected the Bank of England to hike its policy rate to around 6.5 per cent, well above that in the US and the rest of Europe. The UK seemed different.
But there were good reasons to dig deeper. Smaller open economies appreciate the UK tend to be more vulnerable to external shocks and experience higher inflation volatility than larger ones appreciate the US. Indeed, other small open economies, including Sweden, Australia, and Norway, faced similarly high inflation rates.
While Brexit might have added to consumer prices, this was probably a one-off level adjustment, rather than ongoing inflation. The timing of the post-pandemic reopening mattered too. The UK eased its restrictions later than the US, so inflation was likely to follow a similar sequencing. The cumulative rise in core prices since the start of the pandemic was indeed the same in the two countries.
Most importantly, monetary policy credibility seemed intact, with medium-term inflation expectations anchored around the inflation target. Although the BoE’s communication at times appeared dovish, its actions were conventional and hawkish, responding to higher inflation with repeated hikes in the policy rate.
Fast forward to today, and the UK no longer stands out. Let’s start with inflation. Granted, in year-on-year terms, core inflation remains higher than in the US and the euro area. But sequentially, UK inflation is falling sharply, even more so than elsewhere. Annualise the last three month-on-month prints (in seasonally adjusted terms), and core inflation is now even back to the inflation target.
It’s a similar story with wage growth, which remains high at approximately 7-8 per cent in year-on-year terms, but sequentially has been falling recently, and wage surveys point to an even sharper deceleration ahead. When annualising the last three month-on-month prints, wage growth in the private sector is closer to 4 per cent.
Meanwhile, the underperformance in activity was — it turns out — misplaced. GDP has been revised sharply higher and is now almost 2 per cent above its pre-pandemic level, on par with France, Japan, and Spain, even better than in Germany. There are question marks on the reliability of labour market data too.
The Office for National Statistics has recently stopped publishing the labour force survey because of sampling issues. But a new experimental ONS survey suggests the UK unemployment rate fell to 3.5 per cent in the spring. No doubt, some smaller parts of the UK economy still struggle but the broader picture now resembles that of most other developed countries.
Looking ahead, in our baseline outlook, we expect the UK outlook to resemble that in the rest of Europe: broadly stagnant growth, continued normalisation in inflation, which opens up the door for the central bank to ease its policy rate at some stage next year.
But recent market volatility serves as a good example that investors should look beyond the short-term noise. Up until recently, in our expectation that UK inflation would normalise, we favoured gilts over US Treasuries in our global portfolios, with the former yielding about 0.60 percentage points above the latter. The market has repriced sharply since, with gilts now yielding 0.15 percentage points less than their US equivalent.
As such, we have shifted to a more neutral stance on gilts from a relative value perspective, although from an absolute point of view, we continue to find both attractive. US duration — a gauge of a bond’s sensitivity to interest rate movements — in itself offers the potential for attractive return and we also see very good opportunities in other regions such as Australia, Canada, and Europe. Still, the UK’s journey from outlier to convergence reminds us that perhaps it can pay for investors to look under the bonnet.
