What Popular Views Get Wrong on UK Inflation

Summary

• The UK has suffered far higher rates of inflation than many of its peers on the continent.
• Despite the attractive headlines, the biggest reason may be rather mundane: the UK is a victim of peculiar pricing mechanisms.
• We compare UK and German inflation to show a number of key points.
  • Brexit-related supply disruptions are not to blame for the UK’s higher inflation, neither is labour market tightness or wage growth.
  • The timing of the fiscal year (in April in the UK) has helped support inflation.  On the way down, it should help disinflation vs other countries.
  • Policy transmission to the consumer is far faster in the UK not just due to the mortgage market, but also due to the buy-to-let rental market. Perversely, this transmission has exacerbated inflation on the way up.

• The Bank of England does not need to continue to hike to crush inflation. In fact, enough has probably already been done. They will probably continue to hike near-term, but the path to pausing is getting clearer.

Why Is Inflation Higher in the UK Than Germany?

UK CPI is significantly greater than in Germany. These days it is not hard to find someone with an opinion on why that is the case.

• Could it be Brexit causing supply-chain disruptions?
• Or rampant UK spending feeding into a hot economy?
• Or was it the BoE’s fault for all its QE?
• Or is it those pesky wage rises the BoE constantly bemoans?
• Or, perhaps, the corporate profit rises on which it is strangely silent…?

Each of the above may allow for political point-scoring, but all fail to completely explain the situation.

Instead, we conclude that the idiosyncrasies of UK consumer pricing mechanisms are the primary driver of the UK’s underperformance versus Europe in the battle against inflation. However, we believe these headwinds will become tailwinds on the way down.

The BoE’s tightening is already feeding through to the economy more strongly than elsewhere, as evidenced by the comparatively looser labour market. This adds to our long-standing conclusion that the BoE does not need to hike much more to fight inflation. Instead, it would be more prudent policy to retain rates at a high level and allow base-effects to fall out.

Supply Chain Disruptions Do Not Explain Worse UK Inflation

Supply chain disruptions, especially ones related to Brexit, are a staple argument for why the UK has underperformed. However, such arguments ignore the fact that German good input costs (PPI) have been higher YoY in every month since July 2020 (Chart 1). The sector breakdown tells a similar story. Producer inflation across most sectors in the UK undershoots that of Germany (Table 1).

The Labour Market Data Does Not Prove Much Either

Doubtless, wages in the UK have risen far faster than in Germany. However, the wage growth differential has shrunk back sharply from its largest in mid-2022 (NB: German wage data is quarterly, Chart 2). Meanwhile, the alleged Brexit induced labour market tightness is also unsupported by data; both EZ and UK unemployment rates fell sharply in 2023, yet since mid-2022 the UK unemployment rate has bounced back. In Germany it has continued to decline (Chart 3) [1].

It can be argued that the wage differential’s importance is cumulative, so we set this out in Table 2. From 2020-present (Q1 2023 latest data), total wages have risen 10% faster in the UK than in Germany. However, the gap is narrower (avg. 5.8%) when comparing within sectors (to negate the impact of shifts in employment composition). In the last 12 months, the effect has largely reversed with German wages 0.03ppt higher than in the UK, -0.76ppt on average across sectors.

Cumulative UK public sector pay rises since 2020 have outpaced Germany’s by almost 12%, 2ppt higher than they did in the private sector. Over the last year they have continued to outgrow Germany’s. Meanwhile, among the key economic private sectors, services (+11.9ppt) has outpaced most in the UK, while wages in manufacturing, mining, construction and the provision of utilities have grown more similarly in the two countries (Table 2).

So is UK wage inflation growth supporting consumer spending more than in Germany, leading to inflation? The answer is no. Real retail sales are suppressed in both countries, having followed a fairly similar trajectory, with UK lagging slightly behind. This suggests that the latter argument does not hold.

What about the wage cost-push argument? It is important to note that the service sectors in which the UK has seen the largest beat in cumulative wage growth since 2020 are predominantly business (not consumer) facing. Of the sectors that are consumer facing and show high beats in cumulative wage rises, the feed through to CPI differential seems limited: in education CPI is currently higher in Germany than in the UK, while recreation CPI has moved largely in tandem across both countries.

UK’s Inflation Gap Not as Bad as First Appears

As of June, UK headline CPI was +7.9% YoY, while in Germany it was +6.4%. A 1.5ppt spread. Breaking this down (Chart 3):

• The different sector weights explain 0.4ppt of this spread.
• Food, and energy (the most volatile elements) explain 0.2ppt of the remaining disparity (note: transport inflation is now lower in UK than in Germany).
• Three sectors (rent, communications, healthcare) explain 2/3 of the remaining core discrepancy (0.6ppt).

Pricing Structures Explains Most of the Gap

We will focus on rent, communications and health. They are all classed as services, but this does not support the BoE’s focus on how wages drive inflation there. Wages are not in fact the issue.

Instead, the strongest similarity between the three sectors is that they all see consistent, periodic revisions across both the UK and Germany (Table 3).

The timing of the biggest revisions in the two countries follows the pattern of the fiscal year. In the, UK this begins in April, while in Germany, this begins in January[2].

• The timing of the fiscal year plays a role.  All else equal, a firm choosing to revise prices over the last three Aprils, in line with CPI, would have increased them more than revising their prices in January. This is true whether they are in the UK or Germany and is purely due to the timing of when inflation took off (Chart 4).
• Rent in the UK is far less regulated than in Germany. It is dominated by private landlords with heavy exposure to buy-to-let (BTL), predominantly interest only, mortgages. The yield on rental properties is hugely dependent on mortgage rates. Rents tend to be revised annually, clustered in April, and while this appears in CPI, it actually reflects the transmission of monetary tightening – if rental inflation is high, the BoE should actually need to tighten less.
• By contrast, in Europe, rent rises have been more subdued (c. half the rate of in the UK). In Germany, statute (such as Mietpreisbremse in certain areas) helps, but BTL’s dominance in the UK seems to play the biggest part.
• RPI still plays an important part in UK repricing. RPI is the old BoE target. It has typically been about 1ppt above CPI, but this wedge now stands at 2.6ppt. The UK’s telecoms industry has slowly shifted away from indexing on RPI (EE & Vodafone), but some retain (O2). All else equal, this legacy has meant higher price rises.
• UK’s Ofgem household energy price cap is a well understood phenomenon. Designed to provide a fair, steadier price for customers given wholesale prices, it has instead drawn out the feed-through into consumer prices and delayed the time at which the YoY energy component turns negative.

Important Implications for BoE Monetary Policy

The UK suffered particularly badly from inflation due to its unique pricing mechanisms. The BoE could not have countered this, but they should have been able to better predict it and warn about it.

The timing of repricing (in April rather than January) also played a role. This will become a force for net-disinflation on the way down.

Monetary policy transmission to the consumer is far faster in the UK. This is not just due to shorter average mortgage fixing periods, but also due to the BTL rental market passing on costs.

Services inflation continues to show little sign of being driven by wage growth. Instead, it is the least-wage-intensive sectors that have driven its rise (Chart 5).

The BoE does not need to continue to hike to crush inflation. In fact, enough has probably already been done on this front.

However, given the BoE’s established reaction front and its lack of credibility, we expect they will continue to hike in August (25bp seems likely, 50bp is a risk given Governor Bailey’s comments at Sintra). There remains value in fading UK hawkishness.

[1] Note, the outcome is different when considering German unemployment claims – but that has largely to do with the influx of Ukrainian refugees in June 2022, which caused a spike in the rate.

[2] There is nuance to this: in UK healthcare the biggest changes are in January, with April a close second (NHS prescriptions etc. move in April), there is also a strong quarterly/semi-annual pattern for many sectors (as seen in July and October).

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)