Brace for Another CPI Shock

• Over the past week, low US inflation and midterm election results drove markets. UK GDP declined, and the risk of a housing market crash increased as surveys corroborated anecdotes. With BoE pricing now more reasonable, we pushed our curvaceous ECB view.
• Next week is busy for UK releases, with our high inflation forecasts setting up a critical event risk. The Budget may be too well-leaked to be interesting on Thursday, while EA inflation could be revised lower if Italy’s backdated gas price cut counts.

US news was throwing its weight over the past week, moving European markets in the relative void of local developments. So low US CPI inflation was the major macroeconomic release, causing a significant paring of rate hike expectations. That helped drag pricing for the BoE further down towards our forecast, although the move was naturally more at its US source.

Last week, we pivoted our favoured expression for trading the BoE away from this spread after the easy wins were captured swiftly. We instead considered that “the lower peak for the BoE has become more of a UK-specific view”. Having the Fed drive down the peak pricing is a welcome alternative route to the same destination, whereas the spread view we replaced would have suffered. It now looks like time to draw a profitable line under this narrative for the time being.

Although the market still prices the BoE hiking further than our forecast, the difference has become small enough to arguably not be worth trading directly. It may be better to express pessimistic UK views through GBPUSD in the short term. Cable’s rapid rise towards 1.18 looks relatively stretched back at August levels. However, patience could be a virtue if the fundamentals ripen further first. Our UK inflation forecasts are well above the current consensus (preview below), which may shake markets into some more attractive entry points next week.

The US also hogged headlines over the mid-term elections, which proved a closer-run thing than was widely assumed. Control of the House has still switched to the Republicans, though. And the Senate may yet flip control or keep leveraging the Vice President to swing equal votes. Either way, this election outcome will constrain the Biden administration, which was already struggling to pass its legislation. President Biden’s focus will likely turn to areas where he can still impact through executive action, including areas of foreign policy.

Tensions between the US and China remain a worrying focal point for foreign policy. Alastair Newton explored this issue in the context of the Tech war and Taiwan, following up his recent update on how the politics were driving China (see China: The Middle Kingdom Trap, 2 Nov). He asserts that Washington’s explicit shift to containing China’s rise poses a threat to China’s economy and increases the possibility of war over Taiwan — but probably not yet (see China/US: Taiwan).

A lack of scope to act domestically may also impact the policy mix in the US and beyond. As rapid rate hikes bring forward recessionary forces, fiscal policy will be constrained by an inability to pass support, especially when needing to raise the debt limit. That keeps the onus on monetary policy to deliver any stimulus that may be necessary after conquering inflationary pressures.

Monetary policy in the Euro area will also eventually need to loosen back towards a neutral setting. However, the Euro curve slopes upwards again in 2024 even while markets price the BoE and Fed cutting rates. That is inconsistent with our view of the macroeconomic outlook and how the ECB recognises it will need to hike beyond neutral. Keeping rates above neutral would ultimately create disinflationary spare capacity and below-target inflation, which is inappropriate. Cuts back to neutral will eventually be required almost by definition. We see a more curvaceous ECB path as likely to be followed. The monetary policy strategy is now clear, with evidence of falling demand supporting an inversion (see Curvaceous ECB Policy).

The UK seems something of a homeland for falling demand, with its GDP down by 0.6% m-o-m in Sep-22 as the country shut for the Queen’s funeral. At least revisions reversed previous disappointment to return Q3’s fall to 0.2% q-o-q. Unfortunately, surveys suggest activity trends have fallen into recession. We forecast further falls in Q4 and 2023, despite UK output failing to recover its pre-covid levels. The UK still looks likely to underperform its peers as shocks like high rates bind more fiercely (see UK: Funeral for Recovery).

Surveys are starting to confirm anecdotal evidence of the severe shock hitting the housing market in October after the government’s disastrous fiscal event. Mortgage rates in November are yet to follow swaps down, so the pain is still palpable for households. A house price crash looks increasingly difficult to avoid. We now assume a 5% price decline, weighing on the RPI outlook, but see the market on the cusp of a downward spiral fed by adaptive expectations. Crystalising that risk would mean a fall nearer 15% (see UK: Housing Market Skids Toward a Crash).

On the bright side, at least households won’t need to keep enduring the insufferable taunt of crypto enthusiasts to “enjoy being poor”. Cryptos’ latest collapse towards its intrinsic worthlessness means this speculative asset class is returning to an insignificant niche that I can safely continue ignoring.

It will hopefully become possible to stop viewing UK auctions as monetary policy-relevant events one day too. Unfortunately, the BoE’s insistence on symmetrically unwinding its legacy purchases leaves a woefully inefficient setup with multiple large issuers in the gilt market for many years. The friction unloading gilts in its medium auction on Monday was a mild taste of what could come with an eventual long auction. Mediums might not always be safe when auctions are more clustered or in a less conductive market environment again.

BoE sales may soon expand beyond its previously postponed QT into sales of what it bought in the name of financial stability. It plans to start selling those back from 29 November. Thankfully it is avoiding its usual QT approach for these, arguably recognizing that it is still unsuitable for the long end. It will instead create a reverse enquiry window to allow the Bank to fill demand where it exists without forcing bonds down the throat of a market unable to hold them (see BoE News). I want to think the innovation on this part will encourage the Bank to change its broader approach, but I’m not a blind optimist.

Preview: UK inflation in Oct-22

UK inflation returned to directional form in September by surprising consensus expectations to the upside, albeit with the CPI in line with our forecast (see UK: Core Raises Inflation Again in Sep-22). The resilience of core inflationary trends appears to be sustaining that pressure, although surprises elsewhere have been mixed in October. The substantial upside surprise in most European countries should be more indicative of UK pressures than the US downside. So we remain happier being on the high side of the consensus again this month.

Being above the consensus is more of a happy coincidence than a conscious aim, as our granular model-driven forecasts update with data most days and haven’t moved much for Oct-22 over the past month. In this case, we are a little surprised that the consensus isn’t higher as it often carries on the BoE’s coattails after an MPR, and the BoE is in line with our view.

Specifically, we expect UK inflation to surge to 10.9% and 13.9% on the CPI and RPI, respectively. Those are 0.3pp and 0.5pp above the current consensus. We suspect gas and electricity prices may be driving the difference. Some economists may be missing that the energy price guarantee is still a price rise as the ONS decided that the separate rebate scheme equalising the costs wouldn’t count here. However, most economists probably miscalculate the impact as the enormous energy price shock in Apr-22 inflates it.

Figure 1: Contributions to m-o-m UK CPI inflation

Statisticians aggregate unchained component indices, so the “price relatives” also move with developments during the year. That effectively increases the current weight on housing energy by the massive move in April. Applying the current year’s weights to the component growth rates is a conventional approximation, but it doesn’t work well in this case. The difference is worth almost 50bps to the headline RPI rate, which probably isn’t coincidental, given the surprise we expect.

Preview: EA inflation in Oct-22 (final)

Euro area inflation surged again in the flash estimate for Oct-22, this time by 0.7pp to 10.7% (see EA: Flash, Bang, Inflation Fanned). Most final national releases aren’t until next week, so there is still some uncertainty about the breakdown and revision likelihood. We see food and housing energy prices as the prime contributing factors. Germany’s unrevised outcome and Portugal’s 13bp downward revision (see Press Release) don’t change that.

However, Italy enjoys some belated gas price relief after a regulated tariff cut on 3 November that applies to October (see ARERA). If that scores in the Oct-22 HICP, Italy may be revised enough to round the EA headline rate down from 10.657%. A similar trimming happened last month with Spain as the source instead (see EA: Final HICP Trimmed at Excessive High). Italy’s final print is scheduled a day before the EA headline, allowing it to answer the revision question early.

Preview: UK fiscal statement

The last UK fiscal event turned into an unmitigated disaster that marked the rapid end of the then government. Its replacement will take a second stab at the problem on 17 November. This should be an altogether tighter affair that desperately avoids a repeat of dysfunctional market moves. So the OBR will provide a full forecast to bolster credibility. It will also arguably “help” by adding more leaks to the already sieve-like treasury operation to avoid significant surprises on the day.

Overall, there seems little point in running down expectations for the announcements, which you’ve probably read repeatedly in the papers. I wouldn’t be surprised if the Financial Times shares some critical numbers over the weekend, which doesn’t exactly leave space for those of us forecasting as opposed to publishing what might otherwise be deemed material non-public information. So, perhaps controversially, I’ll spare you a detailed budget preview this time in favour of a complete and thoughtful analysis on the day.

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