Is the inflation story over-inflated, and what does it mean for interest rates?

Inflation

The chart above shows the year-on-year change in input pricing, output pricing, and the broader inflation measure: CPI. Input PPI is generally more volatile over time than output PPI. This shows how much inflation is still in the pipeline, arguably still to be reflected through to CPI in the coming months.

At the end of September, the Monetary Policy Committee (MPC) signalled that they expect CPI to peak above 4% and remain there into 2022.

The inflation debate is centred around whether this increase in CPI, driven by “one-off” issues, will be transitory or whether they will linger, becoming second round effects and translating into persistent inflation.

Whilst inflation expectations have increased over the last year to the highest point in the last 10 years, market participants agree with the central bank’s view that the current surge in inflation hasn’t changed the long-term inflationary outlook. The U.K. 10-year breakeven index and U.K. 5Y5Y inflation swap rates have stayed steady across the last six months whilst the RPI index that they are based off has skyrocketed.

The UK 10-year breakeven index is a particulary good barometer of inflation expectations during periods of quantitative easing (QE), and one that the BoE will use when deciding on any monetary policy decision. The breakeven index is simply the difference between the yields in nominal gilts and inflation-linked gilts of a similar maturity. Often, inflation-linked bonds carry a liquidity premium. This effect is marginalised in the breakeven index during times of QE where nominal yields become artifically surpessed.

The BoE has tried to reassure the markets with their recent statements and remains firmly in the camp that the sharp increase in inflation will dissipate next year. Anecdotally, it does not feel that way, having just received an update from Vodafone (my mobile network operator) changing my contract terms from annual price increases of RPI flat to CPI+4%. I have received similar letters from my utility providers and the cost to refuel my car is 25% higher than last month. I don’t expect that when/if inflation starts to revert to the BoE 2% target next year that Vodafone will move my contract back to the old terms. Indicators of households’ medium-term inflation expectations have increased, with the Citi/YouGov 5–10 year ahead measure at its highest level since 2013. Inflation is becoming embedded into expectations, and it’s difficult to conclude that this will not eventually feed through to wage demands, and de facto, persistent inflation in the economy.

Interest rates and MPC decisions

The chart below shows the U.K. gilt market illustrating the large increase in the 10-year gilt yield (another key barometer for interest rate expectations). The chart also shows the spread between the 2-year and 10-year yields. Short-term rates are more influenced by movements in the BoE base rate, whereas slightly longer-term rates have more freedom. The latter provides good indications of the outlook for economic growth and inflation. These are the curves which market participants pay very close attention to in taking the temperature of the interest rate market.

To briefly recap the Bank of England’s policy guidance, the MPC will indicate whether the “necessary” conditions have been met for a rise in interest rates before then deciding whether those conditions are “sufficient”.

At the last meeting in September, four members (including the Governor) thought the necessary conditions had been met. Getting to “sufficient” is another story. The policy guidance specified that they did not intend to tighten at least until there was clear evidence that progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably. At the September 2021 meeting, all members agreed that the previous guidance was no longer useful in the present situation. With this shift in guidance, as well as a change in the make-up of MPC membership, the risk of a surprise decision is high.

Another material shift in the committee’s approach coming out of the September meeting was the unanimous agreement that initial tightening of monetary policy should be via an increase in the bank rate, even if that was before the end of the existing QE programme.

The market is pricing a rise in U.K. rates by February 2022, with some speculating late 2021 (December) could be a possibility. The Governor was clear in his statement that every member of the MPC is ready to raise interest rates before Christmas if needed to prevent higher inflation becoming persistent. He made it clear that a “rate rise could happen very soon if the committee felt higher inflation was becoming embedded in companies’ pricing plans and general wage demands…” At the time of writing the probability of a 15bps rise before Christmas is 85%, and a rise to 0.5% fully priced by May 2022, and 0.75% priced by November 2022. This would take rates back to their pre-Covid levels, which admittedly are still low. The question is whether the economy, and markets can withstand 3 potential rate rises in a 12-month period — which has not happened since 2007.

The next MPC meeting is on 4 November, and also has the publication of the Inflation Report. One to watch very closely.

What does this mean for borrowers and cost of financing?

The forward interest rate curve has moved up between July and September quarter end. The ability to fix interest rates at all-time lows has surely passed.

The cost of hedging against future rises in interest rates has increased substantially. Using a three-year, 1% cap referencing 3-month compounded SONIA, and a notional value of £10M as a proxy, the premium has increased almost eight-fold from £8.9K to £60K, as per the table below.

Given banks’ minimum fees associated with interest rate cap deals varying between £10–£20K, much of the increase in premiums will have been hidden for smaller deals up to this point. Moving forward, participants can expect to face a higher cap premium across deals of all sizes if short-term inflation persists, even in the absence of a material increase in the underlying funding rate itself.

This piece does not address the longer-term outlook for inflation. The short-term noise from the pandemic and the policy stimulus is sidelining attention on the longer-term. Having enjoyed many years of low inflation, you could say that markets and policy makers have become complacent. If you believe globalisation was one driver of the last three decades of low inflation, then the reversal of that trend will have the opposite effect. A topic for a different day, but this idea forms the key tenet of the book by Goodhart and Pradhan: The Great Demographic Reversal. One to add to the festive list perhaps — assuming it is in stock and there is a delivery van with enough fuel to get it to you, or your local bookstore!

Conclusion

• Away from the headline-reported inflation numbers, the market is not yet baking in persistently above target inflation in the U.K.
• Despite the official reported numbers, we are all feeling the impact of higher prices across many different aspects of our lives.
• The BoE is in a tricky position — to keep a lid on inflation expectations while taking into account the risks of a potentially slowing economy.
• The change in stance from the BoE makes the 4 November MPC meeting a critical one to watch.
• Market has priced in U.K. interest rates back to 0.75% by the end of 2022.
• The costs of hedging have increased materially; bear in mind these costs can shift without a change in the underlying rate.