The UK’s monetary policy committee is hardly on top of the situation when inflation is running at more than five times its 2% target
Ouch. Double-digit inflation has arrived in the UK with consumer prices rising at an annual pace of 10.1% in July, a 40-year high. It's a game-changer: Britain becomes the first G7 country in the current economic cycle to breach this psychological hurdle, making it that much harder to defend the underlying economy against inflationary expectations becoming embedded.
Perhaps more surprising is how off-guard Wednesday’s release, following robust wages and employment data a day earlier, caught sleepy sterling markets, which had been lulled into summer complacency by last week’s better-than-expected July US CPI number. UK money markets have responded by pricing in a 50 basis-point hike at the next central bank meeting on September 10, which would repeat August’s outsize increase rather than reverting to the more usual quarter-point move.
With faster rate hikes expected, the UK government bond yield curve has inverted, with two-year yields 12 basis points higher than 10-year levels. It's the widest disparity since 2008, echoing the pronounced inversion in the US treasury market. Yet short-dated gilts are just reacting to events; it's the longer end of the gilt market which is failing to properly price in persistent inflation risks.
The BOE expects a mild but long recession starting in the fourth quarter, though it may be softened by a big fiscal boost from whoever wins the contest to become prime minister, with Liz Truss currently expected to beat Rishi Sunak to become the next occupant of No. 10 Downing Street. It is how that extra spending will be financed that should be worrying the gilt market, as increased supply is surely coming down the pipe.
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