In-depth Analysis

The UK’s problems have been inflated

A week is a long time in politics they say! 

Well “they” are being proved right, in fact, at the moment a day seems like a long time. Such has been the pace of change in policy, and of personnel, at the very top of the UK political tree, and the rotations (or should that be U-turns) may not be over yet.

Sterling has rallied by +2.73% against the  US dollar in the last week, and 10-year UK Gilt yields have fallen by -0.39%, and have printed below 4.0%.

Looking at a monthly chart of these two critical indicators for the UK economy, we can see that some sort of “normality” has been restored.

The problems that have confronted the UK in recent weeks weren’t entirely of our own making, however. Though, it’s fair to say that the communications from numbers 10 and 11 Downing Street, and from the Bank of England, on Threadneedle Street, left much to be desired. Indeed at some points, you wondered if there was any communication between the UK government and its central bank at all.

Exporting Inflation 

One of the biggest external factors that’s contributing to the economic problems in the UK (and elsewhere), is dollar strength. The US currency, as measured by the dollar index, is up by more than +17.30% year to date and by almost +20.0% over the last 52 weeks. 

We can see a clear relationship between the gains in the US dollar, and the rise in UK inflation in this chart. 

A strong dollar effectively exports inflation to other countries, because commodities are priced in the US currency. 

We can see this in action in our next chart, which plots UK inflation against the path of the CRB index, which tracks the performance of a basket of widely consumed commodities. 

As we can see the path of UK inflation broadly tracks the path of the CRB Index.

The CRB index consists of 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, RBOB Gasoline, Silver, Soybeans, Sugar and Wheat. Those commodities are sorted into 4 groups, with different weightings: Energy: 39%, Agriculture: 41%, Precious Metals: 7%, and Base/Industrial Metals: 13%. Trading Economics.

Rising to a peak 

UK inflation for September 2022 came in at 10.1%, just above expectations. The largest contributor to that higher-than-anticipated print was food inflation, with UK food prices rising by an annualised +14.80% during September compared to +13.40% in the August report. We can explore the relationship between inflation and commodity prices a bit further, by introducing a line that charts the price of food. The good news here is that food prices when measured on a global basis, seem to be falling once more. 

Food prices are a function of many factors, one of the most important of which is the cost of fertilizers, which are, in turn, by-products of petrochemicals and energy.

Encouragingly gas prices in the UK and Europe are on a downward path, though they remain elevated when compared to their pre-Covid levels.  

Trying to look forward 

We need to remember that inflation statistics are a lagging or backwards-looking indicator as such they reflect what has already happened rather than what will happen in future.

On balance then, while it’s far too early to say that the UK is out of the woods, there are some signs that inflation may be peaking, and that several major inputs into inflation are trending lower.

That should help both the pound sterling and the cost of government borrowing, as measured by the yield on UK 10-year government bonds or Gilts, which Swiss bank UBS believes could settle in a range between 3.0 and 3.25%.

The path of inflation will help to determine just how far and how fast the Bank of England needs to raise interest rates, which in turn influence the chances of a UK recession, and if we enter one how long and how deep it may be. On that basis alone perhaps it’s time for the UK to stop navel-gazing and turn back to focusing on trade deals and geopolitics that could help to get inflation down even faster.




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