UK : Deflationary forces intensify

In July, the official UK CPI figures surprised on the upside with the biggest driver being a strong rise in fuel prices (petrol and diesel) following a significant increase in demand as the UK and many other countries began to reopen their economies. In August, the UK CPI is down again, confirming that deflationary forces are intensifying in most countries in the wake of the pandemic. The CPI is down to 0.2%, which is the lowest level since the end of 2015, from 1% in the previous month, while core inflation is also down to 0.9% from 1.8% in July. The Eat Out to Help Out scheme implemented by the government to incentivize customers to eat in restaurants and other eating establishments by pushing down the cost of dining out remains the most important deflationary driver (it reduced the CPI by 0.5% on its own) along with airfares that felt for the first time on record in August.

In the short-term, inflation will likely stay subdued as the pandemic scars remain. Rising unemployment, which will probably increase much further in coming months as the furlough is coming to an end in October, will push households to cut their spending, thus putting increased downward pressure on prices. The lowest point for inflation in COVID-19 times has certainly been reached, but we are not getting out from prolonged lowflation anytime soon.

Contained inflation is also confirmed by expectations. In contrast to the post-2008 crisis, where 5Y index linked gilts moved briefly above 5%, currently inflation expectations remain stubbornly well-anchored, around 2%. This is pretty reassuring for MPC members that are worried about expectations. But it adds pressure for the Bank of England to act later this year to stimulate the economy as the risk of hard Brexit is looming. We still expect the Bank of England will widen the scope of its support, first resorting to QE and temporary financing of the government via the “Ways and Means Facility”. We don’t think that negative interest rates, which are part of the toolkit as stated for the first time by Governor Bailey in August, will be used as a first step due to the negative impact on the banking sector.

A gradual rebound in inflation is largely expected by market participants in 2021, when aggregate demand will fully recover and supply-demand imbalances will be reduced. The amplitude of the rebound will also be depend to a lesser extent on two other factors: the evolution of oil prices and any swings in the sterling pound due to the outcome of the UK/EU negotiations.