UK inflation: counting the costs
The inflation show continues to roll on, as recent data have continued to exceed forecasts, with CPI inflation in August rising to 3.2%. The latest figures are the highest since 2012 and jumped by 1.2% over the previous month.
Given base effects from the ‘Eat Out to Help Out’ scheme introduced last August, there were some expectations of higher inflation recordings. However, the magnitude of the increase still came as a slight surprise to market participants.
Food and restaurants contributed to just over half of the annual change, with these levels appearing to be a continuation of the recent narrative of strong consumer goods inflation, shortages in supply chains and global pressures driving up inflation.
The recent increase in natural gas prices has exacerbated inflationary pressures and, with further utility bill increases predicted for April, CPI inflation is likely to reach around 4% by the end of 2021, whilst the RPI inflation market now prices in that measure reaching almost 6% in the coming months.
At the recent Treasury Select Committee, Bank of England Governor Bailey explained how four of the eight Monetary Policy Committee members felt that the pre-conditions for tightening had been met, raising expectations that the Bank may consider some modest monetary policy tightening over the next two years. With the large increases in inflation, they will keep a close eye on measures of future inflation expectations and whether this is influencing wage-setting behaviour in the labour market.
The Bank of England has taken a relatively optimistic view on the recovery; it will be disappointed by recent GDP data that failed to meet expectations, but will believe that the end of the furlough programme should not cause a material increase in the unemployment rate. If it does, however, wage pressures may be muted despite high levels of inflation, which would likely delay any tightening of monetary policy.
Market-based measures of inflation expectations have increased with the rise in commodity prices, with RPI expected to average over 4% over the next five years. This is well in excess of the 3% level that would be consistent with the Bank of England hitting its CPI inflation target. The Bank may, however, find some solace in some medium-term measures of inflation expectations (such as those from surveys and the 5-years, 5-years forward market-based metric) having been relatively stable.
Inflation that is caused by a rise in commodity prices tends to be “looked through” by central banks because, unless they are matched by wage growth, they act as a tax on consumers. Our colleagues Chris Jeffery and James Carrick recently shared their thoughts on the impact of this on UK household finances.
What does this mean for DB schemes?
The continued rise in inflation will not only impact consumers, but also DB pension schemes with liabilities linked to inflation. Such schemes will have seen their actual benefit payments increase in line with inflation; those with high levels of hedging would be less impacted on a relative basis, due to the simultaneous increase in the value of LDI assets held.
In addition, those schemes with a portion of inflation-linked benefits that are capped (e.g. LPI benefits floored at 0% and capped at 5%) will have seen changes in the sensitivity of their inflation-linked liabilities. As longer-dated inflation begins to increase and gets closer to the upper ‘cap’ limit, pension scheme liabilities begin to behave in a more fixed nature (e.g. if inflation is 6%, the increase is capped at 5%, ignoring anything beyond this point) and hence are less sensitive to rises in inflation.
The sensitivity to movements in inflation can be illustrated by the measurement delta, which at the 20-year point has fallen over 2021 by around 9% to the end of August, as shown below:
It is important to note that the interpretation above is based on a market-consistent approach, and other approaches may suggest different metrics in changes of delta over the year (e.g. real world).
Given the change in the dynamics of liabilities, some schemes may consider reducing inflation hedges and increasing fixed hedging, at an opportune time when inflation is currently highly priced. However, every scheme will have different circumstances, so what is the case for one will not necessarily be so for all.