Earlier this month, Federal Reserve (Fed) governor Jerome Powell said US interest rates may need to rise by more than currently priced by the market.
In contrast, Bank of England (BoE) governor, Andrew Bailey, was explicit in stating official interest rates in the UK were unlikely to rise as much as the market expects – despite, in his words, perhaps the largest upside risks to inflation in the Monetary Policy Committee’s (MPC) history.
On the surface, the UK has a bigger inflation problem, with latest year-on-year headline inflation at more than 10% versus above 8% in the US. UK RPI inflation, which sits at 12.4%, exacerbates this differential.
However, the UK and the US are more aligned on core inflation, at 6.4% in the UK and 6.6% in the US, or 5.2% according to the Fed’s preferred core personal core expenditures (PCE) deflator.
Central bankers are now looking at how current policy is likely to impact future inflation. In terms of action to date, the Fed has done more, having hiked rates by 3.75 percentage points while the Bank has raised rates by 2.9 percentage points.
Real 10-year yields in the US are 1.8%, while real yields in the UK remain negative (real yields based off 10-year inflation-linked bonds).
Sterling, key for an open economy such as the UK, has performed very differently to the US dollar. According to J.P. Morgan’s broad effective exchange rate, so far this year sterling is down 5.5% while the US dollar has strengthened by 12.3%.
As if monetary conditions were not already tightening at a much slower pace in the UK than the US, the UK’s quantitative tightening programme has also been delayed – with its first gilt sale only taking place on the first of this month.
US and UK growth dynamics
At the press conference following the MPC’s latest rate decision, the governor was asked directly by a CNBC journalist why it is behaving so differently from the Fed.
Bailey deferred to deputy governor Ben Broadbent, who emphasised the different growth outlooks, drawing particular attention to the latest composite PMI data. Broadbent said the US outlook, based on these indicators, is far better than the UK’s.
He noted PMIs in the UK and US were at 58 and 57, respectively, at the start of the year. He then claimed that UK PMI data is now closer to 47, while in the US it is much higher at 58.
Looking at the latest data, we see that in reality, US PMI is 48.2 (S&P Global US Composite PMI) – the same reading as for the UK. The growth deterioration in the US has, on this basis, been in line with the UK’s.
US and UK composite PMIs – a similar path
Source: S&P Global, as at 31 October 2022
For medium-term inflation, growth relative to potential is key
In terms of inflation and its monetary policy implications, it would have been more informative for Broadbent to talk about growth relative to trend – or relative to the rate of growth at which the economy can expand without creating inflation.
There is much uncertainty about where exactly the trend growth rate is, but we can say with some confidence that it has declined over recent years in both the US and UK.
Various estimates suggest US trend growth was around 3% in the 1980s and is probably closer to 1-2% today. In contrast, the UK is likely witnessing a trend growth rate somewhere between zero and 1% (calling into question former UK prime minister Liz Truss’s aim to see UK growth at 2.5% at a time of high inflation).
We would not be surprised to find trend growth is currently much closer to zero or negative. Why? As the Office of Budget Responsibility (OBR) highlights, the key determinants are productivity, population growth and hours worked.
Evidence suggests UK productivity remains very weak, labour market participation is low, and, as Bailey highlighted, inactivity has been rising. The relative growth outlooks for the US and the UK, adjusted for their respective potential growth rates, may not be as different as Broadbent implied.
In fairness, he also highlighted the impact of the war in Ukraine – which has resulted in a much larger shock to UK energy prices than seen in the US.
However, this is a double-edged sword, not only affecting growth, but also likely to have a negative impact on the trade-off between UK growth and inflation. It implies higher inflation for a given level of growth than what would have occurred prior to the war.
In summary, there has been more monetary tightening coming from rates, currency, and quantitative tightening in the US than the UK.
The growth differences, relative to potential, may not be as large as the Bank suggests, yet the MPC has argued an unchanged rate path is more likely to get inflation back to target than current market pricing.
In contrast, Fed chair Powell believes the peak in interest rates will be higher and stay elevated for longer.
We are more convinced by the arguments presented by the Fed. We do not think the UK is in such a different position that the Bank can go its own way. After all, if UK rates diverge too much from the US, we believe sterling is likely to be impacted, adding further to the already troubling inflation dynamic.
In our view, Bailey and his team do not appear to have the appetite to tackle inflation purely through tighter monetary policy. One thing on their side that may differentiate the UK from the US could be future fiscal policy.
The Bank of England bailed out former prime minister Liz Truss. Perhaps prime minister Rishi Sunak and chancellor Jeremy Hunt will now bail out an overly dovish bank.
Adrian Owens is investment director at GAM Investments. The views expressed above should not be taken as investment advice.