The Outlook for UK Inflation, Interest Rates and Sterling in 2023

Inflation

A consensus view is emerging that inflation is attenuating from its recent double-digit levels in the US, the UK and the Eurozone. That said, inflation is likely to remain stubbornly high in historic terms, for the duration of 2023. Therefore, further rises in interest rates may well prove necessary.

The main reasons for the deceleration in trailing inflation and in inflationary expectations over the next 12 months are twofold. Firstly, post-pandemic, supply-side bottlenecks are easing. Secondly, demand is weakening as the major economies enter mild though probably protracted recessions. Shipping rates have eased as has the price of oil, which is now back down to around $80 – below the level it was at on 23 February before Russia invaded Ukraine. The oil price could rebound rapidly if China regains its growth mojo – something I think is now doubtful as I discussed recently.

As a recession deepens, so demand destruction is reflected in falling commodity prices, and shares in consumer staples tend to outperform shares in material stocks. Inventory levels are rising, especially in the US − a signifier of lower prices to come, for manufactured goods.

The inflation outlook in the UK is exacerbated by the strange phenomenon of people withdrawing from the labour market altogether – something that I examined here recently (The Mysterious Case of the Missing Workers). About 565,000 more people have become “economically inactive” according to a report this week from the House of Lords, under the chairmanship of Lord Bridges. The report estimates that there are 8.9 million economically inactive people between the ages of 16 and 64 – that’s seven percent more than at the start of 2020.

This is an example of how Covid-19 lockdowns seem to have changed behaviour. And yet, labour shortages have not contributed substantially to wage rates in the private sector which are rising at 6.9 percent – well below the level of price inflation. Frances O’Grady, the outgoing TUC general secretary, has said that the Tories have “presided over the longest real wage squeeze in more than 200 years”.

One reason for the phenomenon of early retirement is that amendments to pension legislation under George Osborne made it easier for people to access their private pension pots before retirement age. Another is that, as people reach the pension pot “lifetime limit” of £1,073,100, there is no incentive to make further contributions. There is some evidence, however, that 50-somethings who chose early retirement a year ago have now concluded that they cannot afford to retire and are now seeking work again.

There is increasing evidence that the UK’s labour crisis is being fuelled by an anomaly in the benefits system which encourages people to work no more than two days a week. Claimants can obtain thousands of pounds of extra benefits if they earn no more than £658 per month. People working two days a week can receive £45,000 a year in Universal Credit. To take home the same amount after tax, a worker not on benefits would have to earn £62,000 a year (about the same as a mid-level train driver).

Overall, the Tory reform of the benefits system does not seem to have achieved its main objective of incentivising people to seek full-time work. Moreover, the rise in the number of people who cannot work because of chronic illness or poor mental health suggests that there are lifestyle issues in play which are probably beyond the government’s competence to repair.

Food-price inflation has consistently run above that for other goods. Food prices rose by 16.5 percent in the year to October − the biggest jump since the 1970s. The cost of preparing and cooking the typical British Christmas dinner will be 13 percent higher this year than last, not least because of the cost of Brussels sprouts and vegetables generally. This is more than the general November trailing inflation rate of 10.7 percent, which was itself down from 11.1 percent in October. The cost of two pints of milk in Tesco has gone up from around 80 pence one year ago to about £1.30 now. The price of a block of Cheddar has risen from £2 to £3.

Avian flu has obliged poultry farmers to keep their birds in coops which must be heated in winter. Input prices for farmers – the so-called “3 Fs” of fuel, fertiliser and feedstock – have rocketed. In general, British farmers have not been able to pass on the increased production costs of food to the supermarkets. In some cases, this has resulted in producer strikes – as in poultry farmers refusing to sell eggs to supermarkets. Pig farmers have had a tough time of late. The National Pig Association claims that pig farmers are losing £28 for every pig they rear. Shortages of agricultural labour such as vegetable pickers have caused some farmers to allow fields of vegetables to rot in the soil.

Roughly one half of all the foodstuffs we eat and drink in the UK is produced in this country. As farmers retire – the demographics are against us – so the amount of food we import may have to increase. That makes us vulnerable to fluctuations in food prices in the international markets. The real joker in the pack is the price of wheat, which is an ingredient in about one third of all products on supermarket shelves. If the Ukrainians are unable to plant wheat early in the New Year, then there may be another year of reduced supply from the world’s largest wheat producer. What is clear is that food-price inflation will continue in 2023.

If most economists think that inflation has peaked, the question is how quickly it will fall in 2023 and beyond. Minutes from the last meeting of the Monetary Policy Committee suggest that there was a three-way split in opinion at the 15 December meeting. One imponderable is how much militant trade-union wage demands will flow through into price rises.

I foresee that the UK inflation rate will end 2023 at around the six percent mark – but there are so many variables here, in particular what happens in Ukraine and the direction of the US and Chinese economies as the year progresses.

Interest rates

The Bank of England (BoE) has increased the UK base rate nine times over the past year. It stands at 3.5 percent as the year closes. However, the Bank’s reputation for steadfastness has taken a knock this year. At last, serious commentators have accused the bank of printing too much money for too long and for keeping rates too low and not responding to inflation quickly enough. The Bank still owns £847bn of gilts – with potential consequences that I shall explore soon.

For many traders the most worrying moment of 2022 was not Russia’s invasion of Ukraine, the Chinese demonstrations or the Fed’s third 75 basis-point hike in rates but the implosion in the UK gilt markets in the week after the Truss-Kwarteng ‘kamikaze’ budget of 23 September. Having the currency plunge in the foreign-exchange markets while domestic government-bond yields surge is an outcome usually associated with emerging-market economies such as Indonesia, Turkey, Brazil or South Africa.

Now we know that even G-7 countries which run twin deficits have limited room to manoeuvre, even at a time of historically low interest rates. If prospective tax receipts are falling when rates are rising and growth is declining, a ‘doom loop’ can kick in very suddenly. This was sparked in the UK when pension funds started to sell gilts to raise cash to cover their margin calls on structured vehicles called liability driven investment vehicles. Few of us had heard of these until September. The plunge in gilt prices was only forestalled when the BoE started buying gilts (something it had expressly ruled out the week before) and then when a change in economic policy was signalled by a change in chancellor, swiftly followed by the prime minister’s resignation.

The events in the UK markets in September-October this year were intensely observed from Washington and Frankfurt, where central banks dread the ‘c-word’: contagion. For example, a lack of confidence in the Greek fiscal position arising from the European sovereign-debt crisis of 2011-13 led to fears about the sustainability of government finance in Portugal, Italy, Ireland and Spain (the so-called PIIGS), as well. One of the lessons learned from the Truss debacle was that the BoE had not raised rates fast enough. Indeed, the day before the not-so-mini-budget, the Bank had raised rates by just 50 points when the markets were expecting 75 basis points. I am not alone in thinking that the Bank’s key strategic mistake this year was to resist the inclination to play catch-up with the Fed.

Central banks are supposed to intervene in order to bring inflation nearer to the target rate normally set by the ministry of finance. In the UK that target rate is still officially just two percent – even though trailing 12-month inflation has been consistently well above 10 percent for much of this year. By rights, then, the Bank should continue to raise rates even if inflation falls to say, five-seven percent. However, there is an unwritten law that the Bank should not raise rates while output is falling, as this will only worsen the recession. Also, further rate rises will raise the cost of the government’s debt service and thus imperil the national finances. The government borrowed a record £22bn in November – partly to finance the energy price guarantee and partly to pay interest on its debt.

Further hikes in interest rates will spell misery for families with substantial mortgages whose disposable income is already under downward pressure.

There is also a downside risk that the currently mild recession could morph into a global depression. Economists say that a country is in recession if it records negative growth for two consecutive quarters. Recessions are normally associated with the business cycle – although that concept has rather fallen out of favour in the digital age – and are normally expected to resolve themselves over four quarters. A depression is a fall in economic activity which lasts for years. Recessions can occur at times of pronounced inflation (hence stagflation), but depressions usually become deflationary as in the 1870s and the 1920s-30s with high levels of corporate failure. I will assess the probability of a global depression soon.

My best guess is that UK rates will end 2023 at 4.25 percent, with the realistic promise of cuts in 2024.

Sterling

Sterling has been unexpectedly buoyant of late. The UK economy came close to meltdown when the pound skirted parity with the dollar after the Truss-Kwarteng budget. But now it is back to levels previously seen in early June. As I write (Wednesday), the currency is trading above $1.21 and above €1.14 further to the BoE’s 50 basis-point hike in rates on 15 December.

A stronger currency is good news on the inflation front. A stronger pound makes imports of fuel and food cheaper in sterling terms. If the pound remains buoyant, that suggests that the BoE will not need to raise interest rates as much as might otherwise have been the case – although it is likely to continue to miss its official inflation target of two percent by a wide margin. If the pound flags again, that could change.

Currency traders look at the fundamentals – the trade balance, growth and inflation – but they are also concerned with relative rates, so they look at UK interest rates relative to those in the US, the Eurozone and elsewhere. Further to the Fed’s 50 basis-point rate rise on 14 December, US rates stand at 4.25-4.5 percent. Having made four previous successive rises of 75 basis points, the 50 basis-point rise was hailed as a sign that the Fed thinks the inflation curve has peaked or will peak soon.

Eurozone lending rates were raised to 2.5 percent on 15 December. So, UK rates remain sandwiched between those in the US and those in the Eurozone. But the markets no longer expect that US rates will race away from those in the UK and Europe. Inflation across the Eurozone is still broadly in double digits, and the markets therefore suppose that its rates will have to edge higher in early 2023.

The other reason that the pound has firmed is that the currency markets have determined – for now – that Rishi Sunak and Jeremy Hunt represent two safe pairs of hands which are not going to do anything stupid. No more ‘muppet premium’, then. But the currency story is more about a normalising dollar than a resurgent pound.

While the pound has recovered its poise, it is still well down on the year. It started 2022 at around $1.35, so it has depreciated by nearly 10 percent. I think the chances of sterling regaining the $1.35 level in 2023 are slim as there is more bad news to come in terms of the cost-of-living squeeze and UK growth metrics. Sterling is highly sensitive to flows of international investment and the UK is taking a declining share of international equity investment.

I would expect sterling to edge higher in 2023 but to encounter resistance as it nears the psychologically significant $1.30 level.

PS

Before the New Year I’ll offer a dozen or so predictions for 2023, covering a range of sectors and countries. In the meantime, I wish all Christian readers a merry Christmas and all non-Christian readers a happy holiday.

The iconography of the Christmas festival has evolved radically over time. Christians didn’t even celebrate the birth of Jesus until around the year 350, by which time Emperor Constantine the Great had adopted Christianity as the official religion of the Roman Empire (323 AD). So, Christians, released from their catacombs, were now the establishment. It is actually quite doubtful that Jesus was born at mid-winter − but that date suited the Christian accommodation of paganism.

Christmas trees were a relic of the pagan mid-winter festival which survived in Germany. They were first popularised in Britain by Albert, prince consort to Queen Victoria (1819-61). Charles Dickens published his short story A Christmas Tree in 1850. The Christmas carol, “Oh Christmas Tree!” is a loose translation of the German folk song “Tannenbaum”.

Santa (anglicised in my childhood as Father Christmas) is a derivation of Santa Claus, the Dutch incarnation of Saint Nicholas (who lived in Myra in Anatolia – Demre in modern-day Turkey). But this jolly fat guy who delivers presents to children by entering through chimneys was invented in the US. Apparently, he grew out of the poem commonly known as “The Night before Christmas” (1823) attributed to Clement Clarke Moore (1779-1863).

It was Santa who spawned the commercialisation of Christmas, such that it now has only very tenuous links with Christianity: Christmas as consumption. The current mayor of Demre has tellingly replaced the stone statue of Saint Nicholas with an inflatable Santa.

All these things are evanescent. But whatever your heritage or traditions, I hope this weekend you will enjoy a wonderful meal with people you love – which is what all festivals have always been about, everywhere.