High debt meets high inflation, the UK is in trouble.
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Inflationary pressures are most severe among major developed economies, with government debt as a proportion of GDP rising sharply. The UK economy is set to face big trouble: there is less room for the central bank to further cut rates, and large-scale tax hikes are almost inevitable.
On September 4th, according to news from Chasing Wind Trading Desk, Nomura Securities stated in its latest research report that the UK's inflation rate in July reached 3.8%, far surpassing other developed countries, while service sector inflation soared to 5.0%, affected by multiple factors such as the depreciation of the pound, sluggish productivity growth, and imbalanced wage growth.
Analysts from the firm warned that this stubborn inflation not only may force the Bank of England to pause its rate cuts, but will further intensify fiscal pressures as well.
The report pointed out that the combination of high inflation and high debt levels is exacerbating the UK's fiscal pressure. Since the 2007 global financial crisis, the UK's government debt-to-GDP ratio has increased more than that of all other major developed economies, including the United States.
Nomura Securities said that the current yield on UK 10-year government bonds has risen to 4.80%, a new high since the January peak. The increase in debt interest payments will force the Chancellor to raise taxes in the upcoming autumn budget.
Stickiness of Inflation Tops Developed Economies
According to UK's Office for National Statistics, July's CPI was up 3.8% year-on-year, 0.1 percentage points higher than market expectations, while service sector inflation reached 5.0%, 0.2 points above expectations.
This is the fourth consecutive month of inflation data surpassing expectations, and the eighth consecutive month the market failed to accurately predict UK inflation trends. Nomura analyst George Buckley said:
All components of UK inflation—food, energy, core goods, and service prices—are currently higher than in the Eurozone and the US. Though some special factors have pushed up inflation, including sharp rises in water and sewage charges, airplane ticket price fluctuations, and April's vehicle tax increases, even after stripping these out, the UK's inflation rate would still be the highest in the G7.
From a historical perspective, high inflation in the UK is not a new phenomenon. Data shows, not only for this July, but also for the annual average since the pandemic and the average inflation for 2010-2019, the UK ranks first among the G7.
Nomura also noted that although the UK's average inflation from central bank independence in 1997 to just before the pandemic in 2019 was exactly the 2.0% target, the current stickiness of inflation and the policy dilemma indicate that the UK economy is facing one of its most severe challenges in recent years.
Multiple Factors Driving Up Inflation Pressure
Analysts believe the reasons for the stickiness of UK inflation are complex and varied.
Sluggish productivity growth and unbalanced wage increases are key issues.
In the 2000s, the UK's annual productivity growth was just 1.0%; in the 2010s, it dropped to 0.7%; and since the 2020s, it has only been 0.5%.
More crucially, relative to weak productivity growth, wage growth in the UK is excessively strong.
Since 2020, the UK's unit labor costs have grown by an average of 5.1% per year, far higher than the Eurozone's 3.7%. Catherine Mann, an external member of the Bank of England's Monetary Policy Committee, also mentioned in a recent article the rising inflation expectations and “unexplainably strong” wage growth.
The depreciation of the British pound is also an important factor pushing up inflation.
Since the late 2007 peak, the GBP/USD exchange rate has fallen by more than one third, a larger decrease than for the EUR/USD over the same period, while the UK has a larger international trade exposure (as a share of GDP).
The effects of Brexit are also not to be ignored.
The proportion of the UK's trade flows relative to GDP has clearly fallen since Brexit, which may lead to higher supply chain costs and industrial reshoring, thus pushing up domestic prices and wage levels. According to the Office for Budget Responsibility (OBR), compared with being an EU member, the UK's trade agreement with the EU will cause a long-term loss of about 4% of productivity.
Monetary Policy Facing a Dilemma
The persistence of inflation is reshaping the Bank of England’s policy considerations. Nomura maintains its expectation of two 25bp rate cuts (in November and next February), but emphasizes that this forecast "highly depends on the specific trajectory of economic data".
Nomura said that since the official policy rate is already near what the bank estimates to be the neutral range, any further upside surprise in inflation data could result in the bank pausing or ceasing rate cuts altogether. The central bank may also maintain its £100 billion annual quantitative tightening plan.
External MPC member Mann recently stressed, “If policymakers are uncertain about the persistence of inflation, it’s appropriate to respond to inflation actively.”
It’s noteworthy that there are still two CPI data releases on September 17 and October 22, which will become key observation windows before the Bank of England’s November meeting. Any further inflation upside surprise could completely dispel market expectations of monetary policy easing.
High Debt Amplifies Fiscal Challenges
The combination of high inflation and high debt is significantly intensifying the UK's fiscal pressure. Since the 2007 global financial crisis, the UK's government debt-to-GDP ratio has increased more than that of all major developed economies including the US, potentially lending support to the so-called “fiscal theory of the price level”.
Nomura believes that the soaring burden of interest payments is the main threat. The current yield on 10-year UK government bonds is 4.80%, a new high since January; the 30-year yield has risen to its highest level since the late 1990s. The double blow of high inflation and high yields are pushing debt interest payments sharply higher.
Other fiscal pressures include:
The OBR is too optimistic about economic growth (projecting 1.9% in 2026 versus Bloomberg consensus of just 1.2%); failure to pass welfare legislation has derailed £5 billion per year in expected spending cuts; the government needs a much larger fiscal buffer than the previously announced £9.9 billion.
Nomura Securities believes that the impact of high inflation on fiscal policy is more direct and severe. In the upcoming autumn budget, Chancellor Rachel Reeves faces multiple pressures to raise taxes.
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