For a long time it seemed that inflation was dead. Until the UK’s referendum on its membership of the EU in June 2016, inflation had been slowing for the better part of four years, having peaked at around five per cent in 2011 due to increases in VAT and other administered prices. The Bank of England was doing all it could to stir inflation back to life, but to little avail as wages stagnated in the face of falling inflation.
However, all of that changed swiftly after the EU referendum result was clear. In the immediate aftermath of the vote the assessment of financial markets was dour. Sterling sold off sharply, which fed directly through to an increase in inflation as import prices rose. Indeed, sterling has been the most sensitive indicator of what markets think of each twist and turn in the negotiations, immediately reacting to anything perceived to be good or bad for the UK’s prospects.
The nature of indices means that the impact of the sharp sell-off in sterling should start to wash out of the inflation figures as we progress through this year. All things being equal, you might expect inflation to then go back to the rather subdued levels seen before the referendum.
But the BoE thinks that the domestic economy might finally be in a position to sustain higher levels of inflation. That means that inflationary pressure could be returning to higher levels than we’ve been used to even when the impact of the drop in sterling washes out of the statistics.
There are already signs that the health of the labour market – in which unemployment is lower than at any time since the 1970s – could finally be starting to feed through to sustained increases in wages. This wage growth is a key factor in whether what’s going on in the labour market ultimately feeds through to prices in the wider economy. So although inflation might slow because of the currency effect coming out of the numbers, higher wages will stir more inflation than we experienced before the EU referendum.
This expectation that inflation is going to prove durable is what’s driven the BoE into guiding investors towards three more rate rises over the next three years. This path of rate rises should prove pretty benign. It’s a steeper path than markets had previously thought. but it is still manageable for a small open economy that is ticking along while the rest of the world seems to be in the middle of a boom.
This scenario is based on the Brexit process going smoothly though. The big risk is that if Brexit talks deteriorate it may lead to the Bank facing a difficult trade-off in how to react with rates. A sharp sterling sell-off could push inflation higher. Equally, if Brexit does not go well, the growing price pressure will not leave the BoE much room to cut rates to provide an economic stimulus.
Investors will be better served looking to the medium to long term and beyond factors like the twists and turns of sterling through the negotiations. Rates are likely to rise in May, and the nature of Brexit should become clearer throughout the year.
All eyes will rightly be on the BoE to gauge how they respond to the negotiations. A modest reduction in exposure to the UK would be prudent, but there are too many unknowns to warrant drastic action.
Luke Bartholomew is an investment strategist at Aberdeen Standard Investments
