U.K. Inflation Has Slowed But Remains High As February’s Spurt Surprises

The chart on U.K. CPIH core inflation rate that looks at annualized sequential growth rates of inflation over 12 months, six months and three months shows some remarkable stability. High inflation rates remain in force in the U.K. across horizons. All the different tenors show some slight tendency toward deceleration; however, there's a pronounced flat spot after the acceleration of inflation in early-2022. This ‘flat spot’ embodies a weak downslope that has an extremely mild downward gradient. It is nothing like the speed with which inflation had accelerated in the U.K. It's hard to imagine the authorities would be content with inflation declining at the speed depicted by gradient in this chart. The Bank of England clearly is going to feel that it needs to do more, that it hasn't done enough, that inflation is not declining rapidly enough, and remains too high. The headline and core gains in February underscore those statements.

Got banking issues? On the other hand, there are banking issues. The events in the United States do not reflect something that would have simply passed over the United Kingdom on the way to Switzerland. Any bank operating in the global environment has faced the same circumstances. They've operated in a very low inflation, low interest rate environment. The inflation rate rose sharply. During this period, monetary policy did not react much to the inflation. Suddenly central banks got religion and started raising interest rates. This would have put a great deal of pressure on any security held as the banks would have purchased them under the conditions of a lower interest rate environment. While we can assume that more sophisticated banks have operated more smoothly during this environment, employing various strategies including hedging and the use of financial futures, undoubtedly there are a number of less sophisticated institutions that didn't act that way, didn't see the rate hikes coming, and that may have doubted that the central banks were going to take the aggressive actions they eventually did take. To the extent that there was any denial in the trading room it has been replaced with losses.

Central banks making decisions about policy have to be concerned about the condition of financial institutions under their purview. So far, the Bank of England assess no risk to the U.K. banking system.

Headline inflation in the U.K. shows clear deceleration. The CPIH is at 9.2% over 12 months, declining to an 8% pace over 6 months and to a 6.6% annual rate over three months. For headline inflation, the deceleration is in gear. However, for the core inflation rate, the year-over-year pace is at 5.8%, the six-month pace edges down to only 5.6%, and then, what's worse, is that the three-month pace edges back up to 5.8%. Inflation over this period barely budges. And a 5.8% inflation rate is too high.

The diffusion calculations on the categories in the table show that monthly month-to-month inflation rates are accelerating more than they're decelerating. Diffusion in February is up to 63.6% which says that inflation is accelerating in more categories than it's decelerating. In January, diffusion was 54.5% which also shows net acceleration anything above 50% shows an accelerating tendency. In December, the diffusion index had been better behaved at 45.5% showing a slight tendency for more categories to decelerate than to accelerate.

Sequential diffusion is a little bit kinder to the trends over 12 months diffusion is that 63.6% showing that inflation clearly has accelerated over 12 months compared to 12-months ago. Diffusion over six months compares inflation over six months to the pace over 12 months: here we see a decline in diffusion to 9.1% indicating a sharp tendency to decelerate over six months compared to 12 months (that was not reflected in the pace of either headline or core inflation). However, over three months that marked pace of deceleration in diffusion no longer exists; instead, there is lingering deceleration with a diffusion index of 45.5%. It is rather more modest and only slightly below the neutral 50% mark. And as we just saw, the monthly figures are showing that inflation is accelerating month-to-month so it's not clear exactly how much stock we should place in this three-month index. The headline, remember, showed that inflation had cooled from an 8% pace to a 6.6% pace, but the core had found that inflation accelerated slightly to 5.8% from a 5.6% pace. Diffusion is an unweighted concept looking at the unweighted breadth of acceleration across categories. The main thing that the data are telling us over three months and in the recent months is that there is no strong tendency for inflation to decelerate; the monthly data warn of further acceleration.

U.K. macro data have been a bit touch and go, but the unemployment rate continues to show a tight labor market. But the December rate of unemployment at 3.7% among some of the lower rates we've seen in recent months.

Inflation remains a global phenomenon running at a very high pace in Europe and it's running strongly in the United States. The U.K. core shows little tendency to decelerate, and we also see stubborn inflation in Canada, and even Japan has acquired some inflation although it's skeptical about the longevity of the rate that it's experiencing today.

Summing up There isn't much good news on the inflation front in the U.K. The 1% rise in headline inflation is definitely not good news; the 0.9% increase in the core rate in February is not good news either; the high diffusion measure is not good news. However, what's worse is that the background has deteriorated and suggests that the Bank of England may also face a more difficult environment in which to fight inflation. That's going to be true if it faces anything like the degree of banking problems the U.S. is wrestling with. At this point, the Bank of England continues to issue statements that the U.K. banking system is not risk and remains safe sound and well-capitalized. Still, what else would you expect them to say? U.K. banks have had to operate through the same environment as banks in the U.S. and in Europe. It's hard to imagine that they haven't encountered many of the same problems that we see cropping up at other banks regarding having put on securities that were a high yielding at one point financed by low deposits only to find that interest rates moved higher and inflicted losses on those longer-term securities on their balance sheets. U.K. banks still may be well enough capitalized and may have had enough regulatory oversight to have dealt with this issue as it emerged. For now, we have the reassurance of the Bank of England.