Inflation: looking past the headline

A retro coin operated telescope looking out to see from a pier
For financial professionals only

Who knew an inflation print could be met with such fanfare? The October increase in US CPI of 0.4% - importantly, a little lower than expected – sent markets emphatically upwards. The NASDAQ, an index of US tech companies, went up 8%. In a day.

On the face of it, an annual inflation figure of 7.7% rather than 7.9% is irrelevant to the everyday American, but it’s the knock-on effect that the market cares about.

Taking control

The Federal Reserve (Fed) are on a mission to get inflation under control. To do this, they’ve embarked on an incredibly aggressive cycle of interest rate rises. Just like any central bank, there’s a lot of inflation they can’t control (the parts driven by commodity prices and supply chain disruption, for example), but domestic demand they can influence.

And by influence, I mean restrict. It sounds callous, but when central banks raise interest rates or “tighten financial conditions”, they’re trying to make life tougher for people. Fewer people with jobs and fewer people with money to spend. If the Fed make that happen there’s more chance of them getting inflation under control.

Walking the tightrope

A common phrase by market commentators is a “soft landing”. This is where a central bank manages to raise interest rates and keep inflation in check, whilst also avoiding a recession. It’s a fine line to walk. Given the choice, the Fed has made clear that getting inflation down comes first. But not having too many people out of work is certainly a nice to have.

So why does a lower inflation figure matter so much? It means the Fed might not need to raise interest rates quite as high as expected. Lower interest payments on mortgages. Lower interest payments on personal or business loans. More money to spend on goods and services. That makes life easier for everyone.

Line chart showing headline and core CPI levels from 2004 to November 2022

The market likes ‘easier’, hence the immediate upturn in performance. But to cement this view, we’ll need to see a continuation of the trend.  So both headline and core inflation falling for consecutive months. With each lower monthly reading the market will be pricing a lower chance of higher interest rates, and a potentially painful recession.

UK interest rate expectations down

The UK hasn’t reached this inflection point yet. An increase in the annual headline inflation rate to 11.1 (above expectations) was recorded for October. Core inflation - which excludes volatile components like energy and food - was unchanged.

Line chart showing overall and core CPI from 2004 to November 2022

However, expectations for UK interest rates rises have come down of late, but not for inflation led reasons. Or for any generally positive reason, really. The Bank of England signposted in their last report that the UK economy wouldn’t be able to handle such rises.

The mortgage market offers a good example of the risks ahead. Currently around 80% of mortgages are on fixed rates. Of that figure, around a quarter will end between Q4 2022 and the end of 2023. The vast majority of these are currently fixed at less than 2.5%, a rate far below the variable one they’ll be rolled onto. This could have a material impact on house prices and disposable monthly income.

Bar chart from Bank of England showing that just over 2 million mortgages will reach the end of their fixed rate term by end of 2023

Source: FCA Product Sales Data and Bank calculations.

(a) Number of outstanding owner-occupier fixed-rate mortgages as at 30 June 2022, distributed by quarter during which fixed-rate period expires and by existing interest rate. These data do not include buy-to-let mortgages or mortgages that are off balance sheet of authorised lenders, such as securitised loans or loan books sold to third parties. Mortgages with less than £1,000 outstanding are excluded.

The end may be in sight

Whilst there will be more rate rises ahead, for both the US and UK. We are starting to see signals that the end may be in sight. Inflation passing its peak and financial fragility offer two strikingly different reasons for interest rate rises to slow, but both compelling nonetheless.

All eyes will be on next month’s central bank meetings and inflation print. And after the 30-year UK bond yields incredibly made the mainstream headlines last month, I do wonder if (the more commonly quoted) UK house price indices are primed to take the limelight heading into 2023.

Unless otherwise stated, all numbers sourced from the Bank of England's November 2022 Monetary Policy Report.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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