Does the UK Face a Higher Risk of Stagflation?

Traders and investors had hoped that today's publication of a new reading of the UK Consumer Price Index would bring good news for the country's economy, which is currently in a state of complete disarray. However, the data brought more bad news for the UK's economy and society, and now traders are extremely anxious and the bond market is extremely sensitive in advance of tomorrow's Bank of England monetary policy meeting. The concern on the minds of speculators is whether lawmakers can save the British economy from stagflation.

Background

In the UK, inflation is more stubborn. Prior to April of this year, the CPI Y/Y had been in double digits, but for the past two months it has remained at 8.7%. The GDP data indicates that the country is dangerously close to recessionary readings. There is no doubt that the United Kingdom has self-inflicted many of its problems, such as Brexit and a lack of appropriate responses to COVID-related issues.

Traders have been anticipating a further decline in the United Kingdom's inflation rate today. However, the number gave them an unpleasant surprise: the UK's CPI data printed a reading of 8.7%, which was higher than the expected reading of 8.4%. Investors had hoped that with reduced oil and energy prices, inflation would have declined significantly; however, the Core CPI, which excludes the more volatile components, printed a number that was not only much higher than the forecast (the actual 7.1%, and the forecast was 6.8%), but also has been trending in a direction that investors and the Bank of England find extremely undesirable.

The Bank of England’s Monetary Policy Dilemma

Andrew Bailey, Governor of the Bank of England, has stated that the bank is more focused on the Core CPI data than the aggregate headline number, and he had been optimistic about the development of this number. The bank stated that it must continue to increase interest rates, but was hopeful that Core CPI numbers would decline, giving them breathing room. Now, however, the bank has no alibi to use to soothe the market's anxieties when it announces its monetary policy decision under this spotlight.

Even before the CPI reading, market participants had priced in another 25-basis point increase in interest rates from the Bank of England, as it was evident that the Bank of England was losing the war against inflation. With fuel prices falling despite Saudi Arabia's supply reduction and the possibility of further declines as the U.S. election agenda hinges heavily on how much Americans pay for fuel, it had been hoped that inflation in the UK would begin to weaken.

Now, at its meeting tomorrow, the BOE will struggle to persuade bondholders that declining oil prices will alleviate future suffering. With Core CPI and headline CPI figures so robust and sizzling, bond investors and stock speculators are extremely anxious. More than 2 million mortgages are up for renewal in 2023 and 2024 in the United Kingdom, and interest rates on a five-year period were projected to be 6 percent prior to the CPI data. A hawkish or stern position on inflation necessitates a more aggressive approach to the interest rate increase, which the real estate industry may not be able to withstand. For many investors, the entire situation is nothing short of a ticking time bomb.

Confusion originating from the Sterling Chart

If we examine the price chart of the British pound versus the U.S. dollar or the overall value of the British pound, we can observe that weakness is currently developing. In fact, the chart reveals that there has been a sell-off for the past two days, which began after the mortgage rates offered by some UK banks on a five-year tenure soared above 6% and dominated all headlines. The reason for the decline in the British pound is not that the Bank of England will not fight inflation aggressively tomorrow. In my opinion, the bank's posture is about to become much harsher, which implies that the pound could soon approach the 1.30 level against the dollar.

Chart provided by AvaTrade

It is important to remember that smart money expects the UK government to intervene to save its £1.7 trillion market, and the help, which is currently being delayed by UK lawmakers, could take the form of payment holidays, putting pressure on banks to allow borrowers to fix rates at a lower level for a portion of their mortgages, or providing government mortgage relief. As a result, the current decline in the value of the pound may be temporary, as the Bank is committed to controlling inflation and is compelled to continue raising interest rates.

In conclusion, the economic situation in the United Kingdom indicates that stagflation is a highly probable outcome in the coming days.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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