MARK GILBERT: The evidence is piling up: inflation does not look transitory

Bank of England governor Andrew Bailey says that the cost factors that have driven UK inflation to its highest level in more than nine years will fade. Traders in the sterling markets are starting to disagree with his optimism.

After years when the inflation hawks turned out to be jumping at shadows, I’m starting to think they may finally be proved right.  

Surging energy prices, supply chain disruptions and labour market shortages are conspiring to undermine Bailey’s argument made in a speech last week that “the price pressures will be transient.” That is prompting increased bets that policymakers will have to react to faster inflation even though the nascent recovery in economic growth has stumbled.

The UK is far from alone in seeing price pressures piling up. Inflation in the US and Europe is also leaping higher, and the supply chain problems that have seen shipping costs soar are a worldwide phenomenon. Traders around the world are beginning to question the central bank orthodoxy that says inflation will calm down next year.

But there are domestic issues at play that leave Britain particularly vulnerable, with annual inflation running at 3.2% and the central bank forecasting it will climb above 4% before the year is out.

For one thing, Britain is suffering an acute labour shortage, worsened by its decision to leave the EU and restrict the flow of overseas workers. About 120,000 pigs face being slaughtered for pet food, for example, because of a dearth of meat-plant staff that has left farms with too many piglets and not enough places to store them.

In the energy market, tightening gas supplies in global markets are amplified in Britain, which does not have a large storage capacity and is dependent on fuel imports. UK natural gas futures exploded to a record this week, extending their price gains in the past 12 months to an astonishing 700%.

A shortage of truckers closed swathes of UK service stations as they ran out of fuel in recent weeks. The laws of supply and demand have duly kicked in; the price of petrol has climbed by almost a fifth this year, leaving it just a few pennies short of all-time highs.  

And a worldwide rise in the cost of foodstuffs — the UN’s global food price index has risen 25% in the past 12 months — has ended a nine-month streak of declines in British food costs, with prices set to rise even higher in the coming months. Greggs, which sells sandwiches, baked goods and other snacks from more than 2,100 shops across the country, said earlier this week it is expecting higher costs for ingredients towards the end of this year and into 2022.

A British Chambers of Commerce (BCC) survey published earlier this week showed that 60% of UK manufacturers expect to hike prices in response to the deteriorating economic backdrop. “Acute supply shortages and rising raw material costs drove a historic surge in inflationary pressures in the third quarter,” according to Suren Thiru, head of economics at the BCC.

Concern that inflation will prove sticky is rippling across UK markets. The 10-year break even rate, which gauges expectations for future inflation by measuring the yield gap between inflation-protected gilts and vanilla government debt, has climbed above 4% to its highest level in 13 years. In sterling interest-rate futures, yields have soared in the past month as traders anticipate that the Bank of England will have to raise rates earlier than previously expected.

Bloomberg Economics calculates that the market is pricing in an 80% chance of the central bank raising its official rate to 0.25% from 0.1% by the end of the year. That likelihood is up from about 10% at the start of last month — an astonishingly fast turnaround in expectations that reflects growing speculation among traders and investors that inflation is indeed here to stay.

Managing those expectations, both about where prices will settle and what action policymakers will be forced to take, will make for a difficult balancing act for the Bank of England in the coming months. It cannot afford any missteps.

Bloomberg News. More stories like this are available on bloomberg.com