CPI inflation in the UK is higher than the US, so the market seems to be betting that UK base rates will rise to around 2.5% over the next year.

If it is a race to the top as far as peak rates are concerned there’s no doubt in the markets mind that the Fed will be the winner (or should we say, loser). But is this likely to be correct?

The Bank of England may ultimately have to raise base rates to peak levels that are above those of the Fed – and considerably higher than the market is currently expecting. Right now, the market seems to be betting that UK base rates will rise to around 2.5% over the next year, or so, and then start to ease down while, in the US, the peak is seen at around 3.0%-3.25% over the same period. Hence there is a 50-75-bps gap, but is this justified considering the following facts?

The first is that CPI inflation in the UK is higher than the US; running at 9% compared to 8.3% in the US. More importantly, inflation in the UK is expected to rise to over 10% later in the year, while there seems a good chance that annual inflation has already peaked in the US. This is important for inflation expectations, for while longer-term US inflation expectations (5-10years) from the University of Michigan currently stand at 3% they are up at 4.2% in the UK’s YouGov measure of 5-10yr expectations. While longer-term UK inflation expectations are traditionally above those in the US, this gap has widened significantly in the last two years.

However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy suspects it has done so, because people’s perception of their own personal inflation rate has gone up much more in the UK than the US, and much more than the headline CPI measure. This is down to the fact that huge, unavoidable increases in UK gas prices, partly resulting from Russia’s invasion of Ukraine, have hit consumers hard. The result is that hard bargaining over large wage rises seems likely to be far more prevalent in the UK than the US, and so provoke more persistent inflation.

Don’t forget that while all the focus is on the tightness of the US labour market and the Fed’s claim that it can consequently lift rates fast without causing a recession, the UK also has a similarly tight labour market. Another factor is Brexit. For while it is conceivable that global inflationary pressure could decline as a result of an easing in supply chain stresses, the UK is still likely to have challenges because of Brexit, not least the fact that the full range of checks on goods coming into the UK from the EU have not been introduced yet. When they do, supply from the continent could slow and prices rise again. Yet another issue is that UK inflation is far more susceptible to movements in the exchange rate than we find in the US.

If a fractious global economic and financial market backdrop weighs on the pound more than the dollar we could find that price pressures remain more elevated in the UK than the US. We could go on but, suffice to say, there seem to be far more reasons to think that inflation in the UK is going to be a much more pressing medium-term problem than it is in the US. So why does the market price a lower rate peak in the UK?

This is clearly because the market attaches a much greater probability to a recession in the UK than the US, and that’s perfectly reasonable. We see a recession in the UK as almost a done deal while we suspect that the odds of a recession in the US this year or next are probably no higher than a onein-four chance. If a UK recession blows out the flame of inflation there’s every reason to feel that UK base rates may peak below the Fed funds rate – in the short term.

This “shortterm” is an important point, for while a significant economic downturn/recession in the UK may well cause the BoE to tread more carefully and perhaps pause sooner than the Fed, we are sceptical that demand destruction will eat into underlying UK inflation very much when it is supply that is the problem. “If that’s the case then when we think about the next 3-4 years, not just the next 12 months, we believe there is every reason to expect that UK base rates will vault those in the US - and the market is not priced for this to happen”, Mr. Steve Barrow said.