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Breaking: Unbelievable! Brace Yourself for a Shocking Second Wave of Inflation!

Title: The Challenge of Inflation Persistence in the UK and Strategies to Address it

Introduction:
Inflation persistence remains a pressing concern in the United Kingdom, characterized by idiosyncrasies and long-term mismanagement that have resulted in energy shocks and skills shortages. While there is growing optimism regarding the current direction of the UK economy, it is undeniable that inflation levels are still too high. This article explores the Bank of England’s decision to raise interest rates by 0.25% and why it is viewed as the most effective method to combat inflation and maintain long-term stability.

Understanding the Persistence of Inflation:
The UK has faced challenges with inflation persistence due to various factors, including energy shocks and skills shortages. These issues have had severe impacts on the economy, with both consumers and businesses feeling the strain. Despite this, there is a sense that the worst is over and that the best minds in the country are dedicated to resolving the issue.

The Bank of England’s Role in Tackling Inflation:
The Bank of England has responded to the persistently high inflation levels by raising interest rates. The logic behind this decision is to curb inflation and ensure it remains at a stable and low level. By increasing interest rates, the central bank aims to control the borrowing and spending habits of businesses and consumers, thereby reducing overall demand and inflationary pressures.

Mixed Market Sentiments and Inflation Expectations:
In the market, there are conflicting sentiments regarding inflation expectations. Front-end RPI swaps are priced at a second rising UK inflation over the next year, while the Bank of England aims to achieve a target inflation rate of 2% by early 2025. This discrepancy is puzzling, particularly considering that inflation swap traders have historically been too dovish in their estimation.

Factors Influencing Inflation:
The role of housing costs in inflation cannot be overlooked. With housing costs making up a significant portion of the Retail Price Index (RPI), factors such as mortgage refinancing can impact inflation rates with a lag. However, some experts argue that traders are overanalyzing the situation and that uncertainties surrounding short- to medium-term inflation risk make it unwise to draw too many conclusions.

Barclays’ Perspective and Market Disruptions:
Barclays expects the UK inflation curve to flatten, but highlights challenges in capitalizing on the current market dislocation. Factors such as low liquidity and high transaction costs impede opportunities for customers to profit from the situation. Nevertheless, it is important to approach predictions with caution, given the market’s track record of inconsistency when estimating UK RPI.

Additional Piece:

Exploring the Long-Term Impact of Inflation:
While the persistence of inflation in the UK is a present concern, it is also essential to assess its potential long-term consequences. Inflation erodes purchasing power and lowers the standard of living for individuals and families. As prices rise, consumers may have limited options and be forced to cut back on essential goods and services.

Managing Inflation Expectations:
Central banks play a crucial role in managing inflation expectations. By setting clear targets and implementing effective monetary policies, they can ensure that inflation remains at desirable levels. However, this requires a delicate balance, as tightening monetary policy too aggressively can stifle economic growth.

Strategies for Combating Inflation:
Raising interest rates is one of the key strategies employed by central banks to combat inflation. By increasing the cost of borrowing, it reduces excessive spending and curbs inflationary pressures. Additionally, governments and policymakers must address structural factors contributing to inflation, such as supply chain disruptions, labor shortages, and energy price volatility.

The Role of Fiscal Policies:
Monetary policy alone may not be sufficient to tackle inflation effectively. Coordinated efforts with fiscal policies, such as government spending, taxation, and public debt management, can provide a more comprehensive approach. These measures aim to promote economic stability, investment, and productivity growth.

Conclusion:
Persistent inflation remains a challenge for the UK, driven by various idiosyncrasies and long-term mismanagement. While the Bank of England has raised interest rates as a means to address this issue, market sentiments and inflation expectations remain divided. It is crucial for policymakers to adopt a balanced approach that includes both monetary and fiscal policies to ensure long-term stability and mitigate the adverse effects of inflation on individuals and the economy as a whole.

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There is not much more to write about the persistence of inflation in the UK. Idiosyncrasies and/or long-term mismanagement have resulted in energy shock and skills shortages hit Britain hardest that almost everywhere, but at least the current direction of travel is right, right? The worst is over and we have our best people working on it:

So here’s one thing. Front-end RPI swaps are priced at a second Rising UK inflation over the next year. And while more superficial than the 2022-23 shock, the market-implied 5% RPI peak in December 2024 stands in stark contrast to the Bank of England’s target of reaching 2% by early 2025 . :

Selected front-end RPI forwards © Barclays

Also, while elsewhere inflation markets did not very much over the past month, the market’s response to hot UK data like this week employment relationship was to anticipate a larger localized second wave.

RPI year after year by fastener brands © Barclays

This is strange, not least because inflation swap traders have tended to be too dovish. The reported UK RPI has exceeded the market-implied rate for seven of the last eight readings and for all of the last five:

RPI made vs. © Barclays fixings

A certain type of reader will jump to the now-ish comment box to highlight what RPI includes payment of mortgage interestand that the flip-or-burn nature of the UK mortgage market causes inflation with a lag. JP Morgan published a feature earlier this month on UK mortgages, showing how refinancing higher-rate fixed-term loans will be a two-year problem:

Number of UK term loans maturing © JP Morgan

Housing costs are more than a quarter of RPI by weight. Perhaps remortgaging costs are a contributing factor to the 2024 price? Not according to Barclays rates strategist Jonathan Hill, who believes traders are “trying to be half too smart”:

The reality is that uncertainty is extremely high, and trying to be cautious with the ebbs and flows of short- to medium-term inflation risk is inadvisable, to say the least, other than generally pricing in a deceleration in annual inflation ( largely due to base effects and energy deflation) but stabilizing at inflation prices above target due to upside risk.

Clearly, it is rather silly to imagine that the price of derivatives offers a reliable indicator of where inflation will be 18 months from now. As noted above, the market has been consistently wrong when asked to estimate UK RPI one month out.

Barclays expects the UK inflation curve to flatten – front end to go up, back end to go down or a combination of both – but can’t find a way for customers to profit from the current dislocation. Liquidity is too low and transaction costs are too high.

That said, we probably shouldn’t be reading mashed potato much of the second wave of UK inflation is price-implied, except perhaps that more staunch rate-makers seem to be expecting the worst.

Further reading:
— No, current gilt yields don’t justify Liz Truss, please don’t have us explain it again (FTAV)




https://www.ft.com/content/154b7d9e-21e2-4de3-a4dd-583d5f7b4566
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