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### UK inflation outlook
### Alfred Duncan
Prepared for the Institute and Faculty of Actuaries<br>
28 July 2022

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## Plan

- Current inflation and forecast

- Self-fulfilling inflation risks

- How high can interest rates go?

- Quantitative tightening

<br><br>
These slides (with links to data sources) are available at
[alfredduncan.co.uk](https://www.alfredduncan.co.uk/)

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# Current inflation and forecast

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## Inflation is forecast to increase further

- Latest annual CPI inflation: 9.4% ([ONS](https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/june2022))

- Latest Bank of England forecasts show further increases are likely, expected to
reach 10% in late 2022.

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<img src="images/FanChart.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/monetary-policy-report/2022/may-2022) and author's calculations.

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## Direct energy costs are a contributing factor

- Increased gas and oil prices have been a major driver of inflation, both
directly and indirectly.

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<img src="images/InflationForecastEnergy.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/monetary-policy-report/2022/may-2022) and author's calculations.

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## Inflation is becoming more domestic

- Inflation at the end of 2021 was largely due to tradeables.

- Now, domestic inflation pressure is growing.

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<img src="images/deflator.svg"
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Data source: [Office for National Statistics](https://www.ons.gov.uk/economy/grossdomesticproductgdp/datasets/quarterlynationalaccounts) and author's calculations.

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# Self-fulfilling inflation risks

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## Market inflation expectations

- Inflation expectations can be estimated from  the costs of nominal and
inflation-adjusted gilts.

- (This measure includes risk premia)

- Inflation expectations for July 2022 seem to have fallen back to normal
levels.

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<img src="images/ImpliedInflation_2025.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/statistics/yield-curves)
and author's calculations.

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## Market inflation expectations

- Inflation expectations further in the future have barely budged.

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<img src="images/ImpliedInflation_2030.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/statistics/yield-curves)
and author's calculations.

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## Wage pressure

- Benchmark inflation forecasts expect that wage growth
won't keep up with inflation.

- If wage growth does keep up with inflation, expect higher inflation.

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<img src="images/ForecastRealEarnings.svg"
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Data sources: [National Institute for Economic and Social Research](https://www.niesr.ac.uk/publications/sailing-treacherous-seas?type=uk-economic-outlook) and author's calculations.

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## Wage pressure

- So far, wage inflation is quite low.

- Real pay is back to pre-GFC levels.

- Will UK households tolerate
further falls in living standards?

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<img src="images/awe.svg"
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Data sources: [Office for National Statistics](https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/earningsandworkinghours/datasets/averageweeklyearningsearn01),
[BLS](https://fred.stlouisfed.org/series/LES1252881600Q) and author's calculations.

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# How high can interest rates go?

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## How high can interest rates go?

Taylor principle:

> _To reduce inflation, interest rates must increase by more than the increase
in inflation._

Would imply policy rates well over 8%.

In line with historical experience.

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<img src="images/PastDisinflations.svg"
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Data sources: World Bank, IMF (accessed via [Fred](https://fred.stlouisfed.org/series/FPCPITOTLZGGBR))

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## How high can interest rates go?

Current Bank of England forecasets
are not consistent with the Taylor Principle.

They have been referred to as the "immaculate disinflation."

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<img src="images/ForecastInflationBankRate.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/statistics/yield-curves)
and author's calculations.

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## How high can interest rates go?

High interest rates (> 8%) are probably not necessary due to anchored inflation expectations, and current
debt levels.

- Mortgage affordability tests (until recently) tested affordability up to
    - mortgage rates of 7% or
    - Bank of England policy rates ~ 5%

- Policy rates over 4.2% would push some
industries above historical maximum income / interest expense ratios.

Even with low forecast interest rates, the Bank of England forecasts a
recession in 2023.

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## How high can interest rates go?

Source: [Bank of England](https://www.bankofengland.co.uk/bank-overground/2021/how-sensitive-is-uk-corporate-debt-to-increases-in-debt-servicing-costs-or-earnings-shocks).

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# Quantitative tightening

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## Quantitative tightening

Quantitative tightening will be part of BoE monetary policy.

BoE duration mismatch: high duration assets, low duration liabilities.

Most BoE liabilities pay interest.

If BoE were to make significant losses, this could pose a risk to independence.

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<img src="images/BoEBalanceSheet.svg"
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Data source: [Bank of England](https://www.bankofengland.co.uk/boeapps/database/fromshowcolumns.asp?Travel=NIxAZxSUx&FromSeries=1&ToSeries=50&DAT=RNG&FD=1&FM=Jan&FY=2018&TD=31&TM=Dec&TY=2027&FNY=Y&CSVF=TT&html.x=66&html.y=26&SeriesCodes=RPWB56A,RPWB58A,RPWB9R8,RPWBV79,RPWB55A,RPWB68A,RPWB67A,RPWBL59,RPWZ4TJ,RPWZ4TK,RPWZ4TL,RPWZ4TM,RPWZO8Q,RPWZOQ4,RPWZOQ3,RPWB59A,RPWZ4TN&UsingCodes=Y&Filter=N&title=Bank%20of%20England%20Weekly%20Report&VPD=Y)
and author's calculations.

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## Quantitative tightening

Quantitative tightening is not expected to have significant negative economic
impacts.

Quantiative easing has the biggest impact when markets are disfuntional, otherwise
has negligible effects on inflation, output.

As long as financial markets can remain well functioning, the BoE should be
able to shrink without much disruption.

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