The persistent strength of inflation in the UK has added to the urgency for the Bank of England (BoE) to frontload rate hikes. Our view is that the risks of sustained above target inflation are evident, but in the medium term, a combination of monetary policy and balance sheet reduction will be employed to bring inflation back to target. We inform our view first by addressing the volatile front-end of the curve, which continues to be energy price-led; then turning to medium-term drivers of inflation that could indicate the pace and extent of future rate hikes. In the second section, in the current post RPI-reform environment, we review whether it would have paid off to have hedged a scheme’s CPI-linked risk at the start of 2020.
Ongoing inflation volatility and its policy impact
The record rise in global gas prices saw Ofgem announce the energy price cap increase to 54% as of 1 April, to reflect the quadrupling of wholesale prices in the last year. This means CPI and RPI inflation are likely to rise to 7% and 9% in April, respectively, i.e. the overall market pricing of inflation will rise. This will coincide with a £12bn tax rise for consumers in April via an increase in National Insurance contributions.
Shortly thereafter, state-backed loans and tax rebates were announced, which should reduce the price cap rise to c. 40%. There is a small timing mismatch, however, as the price cap takes effect in April whereas the measures will kick in from October and will spread the impact of higher prices over time, rather than remove its impact permanently. If aligned with wholesale energy futures pricing in backwardation (i.e. prices falling over time), then household energy bills should fall over time and the impact of the redistribution of this April’s rise should be more manageable for households. But this is clearly a gamble by the Government – that energy bills will indeed come down over time. It also remains unclear how the rebate will be reflected by the ONS in inflation statistics due to methodology uncertainty.
The triple whammy of higher interest costs (e.g. mortgage payments), tax rises and higher inflation are downside risks to growth and will hit households’ disposable incomes meaningfully. The impact will disproportionately affect lower income households as they spend a larger proportion of their disposable incomes on gas and electricity; additionally, they face this squeeze with a lower level of savings accumulated during the pandemic. This gives lower-income groups less ability to smooth their consumption across time periods, resulting in weaker discretionary spending and substitution effects amongst products that have faced the largest price increases. This demand destruction should, in the medium term, have a limiting effect on inflation.
The interaction of inflation with rate hikes
At the February meeting, the Monetary Policy Committee (MPC) voted as expected to raise the Base Rate by 0.25%; but the number of dissenters who called for a 0.5% rise came as a hawkish surprise.
The BoE’s projections driving their previous rate hike decision in November 2021 were based on a futures curve for wholesale gas that had priced in backwardation within a few months (light blue line); yet the latest market levels indicate a longer period of elevated energy costs (dark blue line).
Figure 1: UK wholesale natural gas futures curve, at 21 February 2022
Source: LBCM Analytics, Bloomberg, Macrobond
Beyond April and out to 2023, energy prices should normalise and fall out of base effects calculations, assuming the price cap does not rise again within the next 12 months, and supply chain bottlenecks should ease, hence we expect that the inflation profile will have already peaked. That said, inflation is still likely to remain above the BoE’s target which remains a source of concern to the MPC and provides justification for the need to frontload monetary policy tightening.
Surveys showed that in January, UK starting salaries were up by their third fastest pace since 1997 and the latest labour market report found that demand remains robust whilst supply is still weak. The unemployment rate has also continued to decline, despite vacancies rising. This worker shortage borne out of the pandemic is not due to frictional or structural unemployment, instead many are choosing to retire early and leave the labour market due to ill health. From past experience, there is a higher hurdle for these types of individuals to return to the workforce, so labour market tightness may persist longer than previously expected. Furthermore, the UK, unlike the US, does not enjoy elevated corporate profit margins. Therefore, whilst many UK firms are electing to pass through rises in input costs and wage rises in the short term, their lack of pricing power means that in the medium term they will need to rely on productivity enhancements to avoid continued price increases as this could result in demand destruction or substitution away from their goods. This is particularly true of sectors that were previously reliant on an abundant supply of cheap labour. In short, productivity improvements hold the key to the high wage / high growth economy which the UK government aspires to.
In the near term, however, both wages and prices are rising, creating a headache for the BoE. It would be concerned if this begins to feed through to household expectations and multi-year pay settlements, thereby risking entrenching higher inflation into future years. The trade-off is that if the BoE does not intervene now and establish its credibility around controlling inflation, it may be too late to do so, particularly given the lags in monetary policy transmission. The MPC recognises that this increases the risk of exacerbating a slowdown for households that already face a substantial real income squeeze, but the extent and persistence of the current inflation overshoot makes the ’wait and see’ approach less viable now compared to previous hiking cycles where inflation rose more gradually.
What may give the BoE some comfort is that the squeeze for households in the form of higher borrowing rates is proving relatively muted so far. Rates on new fixed mortgages have not reflected the rise in swap rates thus far. This reflects aggressive competition in the mortgage market, but also the significant level of excess deposits in the banking system. As the Base Rate has risen, UK banks, especially those with large current account deposits, have not passed through the full benefit to savers. This greater profitability on deposits allows them to be more aggressive on mortgage pricing. However, this cannot persist indefinitely, and mortgage rates will eventually have to rise to reflect adequate compensation for default risk and meet banks’ hurdle return on capital. Nonetheless, this means that the concern about higher base rates exacerbating the squeeze on the consumer is less of a concern for the BoE in the interim and may therefore provide some cover for continued hikes.
A review of the post-reform RPI-CPI forward wedge
The High Court approved a judicial review into RPI reform to begin this summer. If successful, holders of inflation-linked bonds could receive compensation. Whilst we still see this as an unlikely outcome, there is now a non-zero risk that reform is reversed and may keep the RPI-CPI forward wedge from going to zero from 2030 onwards.
With current heightened volatility in inflation markets and the RPI-CPI realised wedge having widened to remarkable levels, a post-reform review of the wedge is very timely. In January, the wedge reached its widest level since 2007, primarily driven by RPI surprising to the upside and surpassing the rise in CPI. This can be attributed to house prices continuing their march upward (rising 10.8% year-on-year in December). The forward wedge has also risen in the longer end, so relative to November 2020, the forward wedge is higher across all tenors except for the belly of the curve.
Source: Columbia Threadneedle Investments, Morgan Stanley
Figure 3: Comparison of pay-offs for having entered into a 15-year basis trade in January 2020 vs not hedging the basis risk, at 31 January 2022
Source: Columbia Threadneedle Investment, Morgan Stanley
The supply and demand dynamics of CPI hedging
On the supply side, energy and utilities firms access public capital markets to manage their CPI risk, whilst on the demand side there are pension schemes and insurance companies. However, the latter are less prominent as post-2030, RPI will adjust to CPIH and hence the opportunity costs of hedging CPI risks are lower, particularly if the outcome of the court case is in favour of pension schemes (i.e. they receive compensation, so it would make sense for them to retain RPI-linked assets that would benefit from this scenario). Nevertheless, there continues to be activity on the supply front, with more expected as the fourth round of Contracts for Difference (CfD) auctions were announced in December 2021. This may prompt the hedging of this CPI exposure, leading to some activity in April or May, on the assumption that previous allocation rounds have taken 4 to 5 months to conclude. This may lead to a continued gradual widening of the wedge as supply / demand dynamics become less acute than they have been historically, amidst continued interest from corporates to hedge their CPIH-linked revenues.
Conclusion
It truly is a difficult balancing act for the BoE as it weighs up the risk of higher inflation becoming entrenched into future expectations against the potential for the ’cost of living crisis’ to drive slower growth. With each inflation print, we have seen the market revise their terminal rate forecasts upwards, such that these are now all higher than the BoE’s expectation of just over 1.0% by the end of 2022. Rate hikes may not always rein in inflation effectively if the inflationary shock is more supply-side driven and could lead to the undesired result of an economic slowdown. However, once near-term energy price volatility and goods price inflation abate, the outlook for medium-term inflation will largely depend on wages. We will be following the persistence of labour market tightness and the evolution of productivity trends post pandemic most closely, whilst recognising that these are both inherently difficult to predict.
2 The scheme purchases a CPI swap (i.e. receives CPI) and simultaneously sells an RPI swap (i.e. pays away RPI).
