Column: Team Transitory

LONDON, Nov 18 (Reuters) – In all the din surrounding Britain’s patched-up public finances, one upshot for the government’s budget watchdog is that the economy is heading for outright price deflation within three years.

That’s quite a forecast, with UK inflation currently running at 41-year highs of more than 11%, and it likely reflects extreme base effects from flattening household energy prices or the mother of all recessions – or both.

But taken at face value, the expectation of two full years of falling prices suggests to many that the twin tightening of Bank of England interest rate rises and a public spending squeeze backloaded to 2024 is simply policy overkill for an economy already in recession.

And for financial markets it begs the question as to whether the extent of the monetary or fiscal tightening currently assumed will ever actually happen.

The eye-catching inflation outlook, embedded in the independent Office for Budget Responsibility’s costings and forecasts from finance minister Jeremy Hunt’s revised budget plan on Thursday, seems sticky enough for next year.

But then it falls off a cliff.

The OBR reckons UK consumer price inflation has now peaked and will back off to a full-year rate of 7.4% next year. But assuming standing market forecasts for energy prices and BoE rates, it then sees inflation fall below zero for eight quarters from the middle of 2024.

Of course this year’s wild energy price swings and related government subsidies announced in Thursday’s budget add huge uncertainty and distortion to headline inflation forecasts.

As it takes the 55 billion pound fiscal squeeze into account – and the fact that spending cuts that account for half of that don’t kick in until after the 2024 election – the OBR’s projected inflation swoon over three years is much deeper than Bank of England’s own outlook from earlier this month.

The BoE also expects headline inflation to plummet into 2024 – and its ‘fan chart’ of the range of possible outcomes also has an outside chance of deflation then too.

Yet its central forecast from Nov. 3 was that, based on current market projections, quarterly inflation will remain positive over the 2024-25 period, even if below the BoE’s 2% target.

Eight quarters of deflation is a different matter.

OBR chart on inflation forecast
OBR charts on forecast assumptions


Underlying the OBR forecast is an assumption that natural gas prices will halve by mid 2025 but BoE rates would remain above 4% for that entire period too – at least a full percentage point higher than at present.

Sceptics will argue that any inflation or economic forecast beyond the next 18 months – especially in the current unpredictable environment – is a finger in the wind.

And yet policymakers and markets still have to make decisions based on them today.

For market economists, the extreme modelling outcomes most likely reflect how current pricing of future policy may be wide of the mark – and therein lies a cat and mouse game of credibility that was illustrated in Technicolor this summer.

“This is another implicit sign that the Bank Rate won’t need to rise as far as markets expect,” said ING economist James Young, pointing to market-implied BoE policy rates still as high as 4.5% next year and staying there right through 2023.

“Part of the reason why the Chancellor has back-loaded a fair chunk of the fiscal pain rests on a hope that the OBR will be able to revise down debt interest costs further in future if rate hikes do indeed undershoot market expectations,” he said, adding that meant austerity need not be quite as aggressive.

That leaves two big questions for sterling – will it be undermined by an eventual reality check when markets reduce nominal Bank rate forecasts, or bolstered by beefed up real yields if inflation falls very quickly?

Much hinges on how much additional risk premium continues to be demanded by investors to stay in UK government bonds following the credibility-damaging September faux pas.

Delaying spending cuts until after an election won’t help much in that regard if indeed they’re seen necessary at all.

Vivek Paul, UK Chief Investment Strategist at the BlackRock Investment Institute (BII), said rebuilding credibility comes with economic costs and the UK Treasury will for years be wary of the ‘bond vigilantes’ that hastened the demise of the previous Prime Minister and finance chief.

Paul reckoned the so-called ‘term premium’ – the compensation investors demand for holding longer-maturity bonds – will return in the UK over the coming years.

“The next general election (is) a potential catalyst if markets believe that today’s backloaded cuts will ultimately not be delivered or are not replaced with a credible alternative plan,” he said, adding BII’s long-term positioning would steer away from gilts and remains underweight UK stocks.

Reuters Graphics Reuters Graphics
Reuters Graphics Reuters Graphics

The opinions expressed here are those of the author, a columnist for Reuters.

by Mike Dolan, Twitter: @reutersMikeD; Editing by Kirsten Donovan

Our Standards: The Thomson Reuters Trust Principles.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.

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Mike Dolan is Reuters Editor-at-Large for Finance & Markets and has worked as an editor, correspondent and columnist at Reuters for the past 26 years – specializing in global economics, policymaking and financial markets across the G7 and emerging economies. Mike is currently based in London, but has also worked in Washington DC and Sarajevo and has covered news events from dozens of cities across the world. A graduate in economics and politics from Trinity College Dublin, Mike previously worked with Bloomberg and Euromoney and received Reuters awards for his work during the financial crisis in 2007/2008 and on frontier markets in 2010. He was a regular Reuters columnist in the International New York Times between 2010 and 2015 and currently writes twice weekly columns for Reuters on macro markets and investing.

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