At the Spring Statement Chancellor Philip Hammond stated that UK inflation would fall towards the Bank of England’s (BoE) 2 per cent target in the next year. UK inflation peaked in late 2017 at 3.1 per cent, but has fallen to 2.5 per cent in March. Although the Monetary Policy Committee (MPC) expects inflation to continue to moderate over 2018, as a result of an appreciation in sterling, domestic inflationary pressures are expected to build, which will likely keep inflation above the 2 per cent target for an extended period.
The Bank of England (BoE) estimates that the rate at which the economy can grow while maintaining balanced domestic inflationary pressure is around 1.5 per cent per annum. This is the level of growth at which the amount of spare capacity or slack within the economy is neither rising nor falling. This level of growth is commonly referred to as ‘potential growth’. With the UK economy growing beyond this level in recent years, the level of economic slack has reduced.
A concern for the BoE is uncertainty regarding the outlook for potential growth. Lower population growth, the low level of unemployment and weak productivity growth are all factors which could result in lower potential growth over time. Potential labour supply, for example, is now expected to rise by just 0.4 per cent per annum over the next three years, significantly lower than the average of 1.2 per cent per annum experienced since the global financial crisis.
With spare capacity at such low levels, any positive growth surprises will put upward pressure on medium term inflation forecasts. There is also a growing risk that forecasters have become too complacent on the outlook for wage inflation. The lack of wage inflation in recent years has been a major factor behind the low inflationary environment, but labour markets have tightened and the period of low wage growth may be drawing to a close.
Looking deeper into headline wage data, a regional breakdown suggests that the subdued level of wage growth has not been uniform, and that headline data masks some important underlying trends. In London for example wages grew by 5.3 per cent on average in 2017. The question is whether this is a precursor for broader wage gains across the UK.
UK wages have been held down by public sector pay, where government policy has constrained wages. Pay discussions in 2018 indicate that this is now changing, with National Health Service staff being offered a pay rise of at least 6.5 per cent over the next three years, with some staff to receive pay increases of up to 29 per cent.
The BoE have already upgraded their forecast for wage growth in the first half of 2018 to 2.75 per cent from 2.5 per cent in the February Inflation Report, and there is a risk that expectations continue to drift upwards.
Whilst short term inflation has moderated more quickly than expected, the medium-term picture is deteriorating. The low level of wage growth is a conundrum given historically low unemployment levels, but the risks of more meaningful gains in wages are rising and some underlying employment data is concerning. Spare capacity is low and with global growth performing well there is a risk that the UK economy could grow at a faster pace than forecast. If this were to occur then it is likely to stoke domestic inflationary pressures even further.
These factors provide a clear rationale for why the MPC shifted to a more hawkish position and started to tighten interest rates. Even under their current scenario the MPC expect inflation to be at 2.2 per cent over two years and still above target at 2.1 per cent over three years. For investors, it is important to remain vigilant. Nominal yields in developed markets are likely to rise in coming years, as the European Central Bank are expected to draw their quantitative easing program to an end and fiscal reforms in the US ramp up supply. For UK inflation-linked bonds the technical outlook may be more attractive. Demand from pension funds continues to be strong, whilst there is speculation that the UK government may start to reduce inflation-linked issuance in coming years, as inflation-linked bonds represented around 28 per cent of UK debt stock at the end of 2017.Dave Hooker is manager of the Insight Inflation-Linked Corporate Bond Fund.
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