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14 December 2022

What if inflation falls in the wrong way?

Bond markets have suggested US inflation could fall by the most since 2008 next year – which could be catastrophic for the UK.

By Emma Haslett

People with “lower inflation” on their Christmas lists might be about to get their wish. The Office for National Statistics (ONS) published figures this morning (14 December) showing that the consumer prices index has dipped to 10.7 per cent, lower than the 10.9 per cent economists were expecting. Meanwhile in the US, the Federal Reserve announced yesterday that consumer price inflation slowed to 7.1 per cent in October.

However, an obscure financial market indicator has also just predicted that inflation in the US could be on the brink of a much sharper downward turn – and this might not be good news for the US and other economies.

The indicator in question is the gap between yields on one-year Treasury Inflation-Protected Securities (Tips) and one-year US Treasuries (government bonds), which now stands at 2.18 per cent. The gap between these two products is the gap between what interest rates are now, and where bond investors think interest rates will be over the next year.

What this means is that bond markets are pricing in a sharp reduction in the rate of inflation in the US, which they predict will fall by five percentage points over the next year. This would be the steepest disinflation in the US economy since the 2008 financial crisis.

What matters is why inflation is falling. Christopher Martin, a professor of economics at the University of Bath, says there are two ways it could happen: “Inflation could fall because there’s a sudden boost in in supply, and everything’s going great – or inflation could fall because there’s a collapse in demand, and things get a lot worse.” The second scenario is what we saw during the financial crisis in 2008.

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The old cliché goes that when America sneezes, the world catches a cold; disinflation caused by a recession in the US could have profound effects on the UK. “The US is buffeted by the same forces we are,” says Martin. “So if it’s the case that US inflation is beginning to moderate a little bit, that’s probably a sign that ours is also beginning to moderate, and will moderate reasonably soon.”

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On the surface, that would be a good thing. High inflation – driven by rising energy prices because of the war in Ukraine and, to a lesser extent, supply chain problems caused by the pandemic – has been a major cause of the cost-of-living crisis and the strikes that afflict the UK. “If inflation falls, it basically means the Fed [the US central bank] has done its job,” says Giles Coghlan, chief markets analyst at the broker HYCM. If that’s the case, great: central banks can then begin to pull back interest rates, and borrowing gets cheaper.

But a sudden, big fall in US inflation could also be terrible for the UK. Markets have only expected a five percentage point drop on a handful of occasions – the most recent being when Lehman Brothers collapsed. Coupled with an inverted yield curve, this indicates that investors are expecting a recession in the US.

That could be the last thing the UK needs, because the UK counts the US as its most important single trading partner, making up 16 per cent of demand for our goods. At a time when the UK has already endured a 15 per cent drop in trading thanks to Brexit  (according to the Office for Budget Responsibility), a fall in demand from a recession-hit US could be disastrous.

There is also another risk: that inflation doesn’t disappear at all. Coghlan believes the main risk comes not from inflation falling too suddenly, but from it being “too sticky”, with employers regarding a slight dip in price rises as their cue to increase wages – causing inflation to jump again. “The biggest danger is that we take the foot off the gas too quickly and we end up having a wage-price spiral because we end up giving increased wages to a lot of different workers,” he says.

Faced by a similar situation in the 1970s, the Fed chief Paul Volcker was forced to raise interest rates until unemployment hit 10 per cent. “It was agony, it was awful for people,” says Coghlan. “Most people will say, let’s try and delay this a little bit. But it’s a bit like trying to cut out a cancer – you think, I won’t cut out too much of the flesh around the outside, and then the risk is the cancer comes back. Maybe if you cut off the limb, you wouldn’t have had to deal with it at all.”

It is likely that whatever is going to happen, it’s already begun. Yesterday’s data from the US showed inflation at its lowest in a year. That could be good news for US consumers, showing that the Federal Reserve’s medicine – hiking interest rates – is beginning to have an effect on inflation. On the other hand, it could be the beginning of more pain to come.

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