Thursday, October 1, 2009

UK Inflation Expectations: Overstated

By: Christopher Hodge
Analyst, Pharo Management

Recently, UK Prime Minister Gordon Brown, and Business Secretary Peter Mandelson announced the extension of the British version of the "cash-for-clunkers" program (, raising the government expenditures associated with this program to £400 million. While this may win the Labour Party some votes in the upcoming election, the increased fiscal obligations resulting from spending of that kind have certainly caught the attention of those concerned with the inflation outlook in the UK.

Inflation expectations have greatly increased with the rampant spending by the British government, and while such massive spending has almost certainly prevented an even more disastrous collapse of the UK economy, the spending is taking its toll on some aspects of the economic fundamentals.

In April, the Treasury projected that in the current fiscal year (ending in March 2010) the deficit will be at a post-war record of 12.4% of GDP, and now even that estimate looks modest. The rise in debt from 2009 to 2010 is the sharpest increase among G-7 nations, and the increase is projected over the medium term as well. In its April budget, the government said that debt will rise to 76.2% of gross domestic product in the fiscal year ending March 2014 from just 36.5% of GDP in the fiscal year ended March 2008 (

There are signs the UK economy is improving, and the IMF announced this week that it expects GDP growth in the UK to be about 1% next year. However, the economy, though poised to show positive growth in Q3, remains fragile and further government spending may be necessary - particularly, in view of an upcoming parliamentary election next spring. While it's highly unlikely that the UK defaults on its debt, investors are concerned that the government may be tempted to decrease the debt burden via inflation.

Evidence of the growing inflation can be found in the bond market, where break-even rates have almost doubled for 10-year bonds since March of this year. (see chart below)

Break-even rates are the spreads between conventional government debt and inflation-protected debt. Higher spreads reflect investors' increased concerns for future inflation. The market is currently pricing the UK inflation-protected bonds at a higher premium than any other G-7 country (see chart below).

Although the recent increases in spending are troublesome, the inflation uneasiness seems overstated by the market. The markets' current pricing of break-even rates, while high, are not unheard of in the UK. The mid-to-late 1990s saw an even greater threat of inflation. Since being granted independence in 1997, however, the Bank of England's Monetary Policy Committee has been quite vigilant in its fight against inflation. In fact, current BoE governor Mervyn King has been criticized for failing to ease monetary policy quickly enough at the onset of the current crisis. Now the market seems to believe that the BoE will miss expectations on the upside. The BoE has had a good track record of being fairly cautious with regards to signs of future inflation and should be trusted as well this time to do the same. To be sure, a watchful eye should be kept on UK deficit spending, but current break-even rates are probably far fetched.


  1. I think you made some key points but, wouldn't economic recovery in the US and Europe drive increased domestic demands for oil as well as increase demand by the Chinese?

    For example, if oil were to say increase to $100 barrel, still ~40% off the high of last year would the subsequent inflationary pressures negate any deflationary benefits generated by the unwinding of government program like cash for clunkers?

  2. Sure, an oil shock would raise both inflation and breakeven rates of all importing nations but the current pricing of the rates is implying a significantly greater vulnerability for the UK than other G-7 nations even though many other nations have similar fiscal packages in place. It is my view that Mervyn King and theof the doubt in this case. BoE (as well as Trichet for that matter) have given us little reason to doubt their anti-inflation commitment and they deserve the benefit of the doubt in this case.