Column: Transitional Team: Is Britain heading for deflation?

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

That’s a pretty good forecast, with UK inflation currently at 41-year highs of over 11%, and probably reflects the extreme base effects of flattening domestic 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 Bank of England’s tightening of interest rates and cutting government spending delayed until 2024 is simply overstated policy for a economy already in recession.

And for financial markets, the question arises as to whether the degree of monetary or fiscal tightening that is currently assumed will ever occur.

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

But then he falls off a cliff.

The OBR believes that UK consumer price inflation has now peaked and will recede to a full annual rate of 7.4% next year. But assuming the BoE’s standing market forecasts for energy prices and rates, you then see inflation fall below zero for eight quarters from mid-2024.

Of course, the wild swings in energy prices this year and the related government subsidies announced in Thursday’s budget add a lot of uncertainty and distortion to overall inflation forecasts.

Factoring in the £55bn tax squeeze, and the fact that half of the spending cuts don’t come into effect until after the 2024 election, the OBR’s projected three-year fade in inflation years is much deeper than that of the Bank of England. own perspective earlier this month.

The BoE also expects headline inflation to plummet in 2024, and its “fan chart” of the range of possible outcomes also has an external possibility of deflation at that time.

However, his central forecast on November 3 was that, based on current market projections, quarterly inflation will remain positive over the 2024-25 period, even if it falls below the BoE’s 2% target.

Eight quarters of deflation is something else.

OBR Chart on Inflation Forecast
OBR Charts on Forecast Assumptions


Behind the OBR forecast natural gas prices are supposed to halve by mid-2025, but BoE tariffs would also remain above 4% throughout that period, at least a full percentage point higher than in the present.

Skeptics will argue that any inflation or economic forecast beyond the next 18 months, especially in today’s unpredictable environment, is a toe in the wind.

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

For market economists, extreme model results most likely reflect how the current price of future policy may be off, and therein lies a cat-and-mouse game of credibility that was illustrated in Technicolor this summer.

“This is another implicit signal that the bank rate will not need to rise as much as markets expect,” said ING economist James Young, noting that the market-implied BoE policy rate will remain at 4.5% next year. year and will remain there until the end. 2023.

“Part of the reason the chancellor has refinanced a good deal of the fiscal pain is based on the hope that the OBR will be able to revise the interest costs of the debt down in the future if rate hikes actually outpace market expectations,” he said. , adding that this meant that austerity did not have to be so aggressive.

That leaves two big questions for sterling: will it be undermined by an eventual reality check when markets cut nominal bank rate forecasts, or will it be bolstered by bolstered real yields if inflation falls too quickly?

Much depends on how much additional risk premium investors continue to demand to stay in UK government bonds after the September misstep that damaged credibility.

Delaying spending cuts until after an election won’t help much in that regard, if it’s deemed necessary at all.

Vivek Paul, chief UK investment strategist at the BlackRock Investment Institute (BII), said rebuilding credibility comes with economic costs and the UK Treasury will mistrust for years the “bond vigilantes” who hastened the demise of the bond. former prime minister and chief finance officer. .

Paul calculated that the so-called ‘term premium’ – the compensation investors demand for holding bonds with longer maturities – will return to the UK in the coming years.

“The upcoming general election (is) a potential catalyst if markets believe that today’s delayed cuts will ultimately not be met or replaced with a credible alternative plan,” he said, adding that BII’s long-term positioning would move away. gilts and will remain underweight UK stocks.

Reuters charts Reuters charts
Reuters charts Reuters charts

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

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

Our standards: The Thomson Reuters Trust Principles.

The opinions expressed are those of the author. They do not reflect the views of Reuters News, which, according to the Trust Principles, is committed to integrity, independence and non-bias.

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