Inflation in the U.S. just surprised economists to the upside, beating consensus estimates of 1.9% and clocking in at 2.1%. Now that it increasingly looks like inflation could be a big factor in the 2018 financial picture, it may actually be the U.K. that will be the test case for how inflation will be handled, and how high it could go.
Why is that? Because the U.K. is ahead of the rest of the world when it comes to inflation. It is among the first countries in the West since 2015 to see an inflation rate above 3%. If the Bank of England can't quickly quell these price gains, investors should seriously consider inflationary hedges like gold and other commodities.
The upside inflation surprised was reported one day before the upside surprised in the U.S., and the somewhat worrying number has pushed the Bank of England to raise rates faster than it previously anticipated. The Bank of England now has the stated goal of getting inflation down to its 2% target within the next two years instead of three. The question is, what happens if the Bank of England cannot get an immediate grip on the inflation trend? With rates already rising in Britain 108 basis points on the 10-year since bottoming, how high will rates have to go to quell consumer price gains? And can Britain’s economy handle what would be necessary considering the fragile state that Brexit has already caused?
What’s more, UK consumer prices have already seen the longest, most sustained rise since the 1980’s. The last time when inflation picked up in a sustained pattern was from April 2009 to October 2011, for a period of two and a half years. During that time the U.K. inflation rate picked up from 1% to just over 5% and then began to fall. This time, the trend of rising prices has continued for two years and 10 months, longer than any period in decades.
But here’s the really interesting part. Consumer price gains in Britain have not been solely the fault of the Bank of England. In fact, Bank of England money printing has been pretty mute since 2010. The UK pound sterling supply as documented by M2 by the Bank of England has risen only 12% since 2010, a very low figure compared to other Western countries. The euro supply by comparison has increased 36%, and in the U.S. the dollar supply has skyrocketed by 63% over the same time frame. So why should the UK be the first to experience 3% inflation rates?
Much of the blame for the price inflation in Great Britain can be placed on forex markets discounting the pound after the Brexit vote and making imports more expensive for British consumers.
Which raises another important variable here. With the money supply much more inflated in the U.S. and eurozone since 2010, the potential for rapid consumer price gains seems very real, at least on the money supply side. If we are to see the U.K. as a test case, all that is missing for the U.S. and eurozone are the increases in import prices a la what Brexit caused, maybe due to some political development or other involving trade and tariffs.
President Donald Trump now openly says that he wants a “reciprocal tax” where he would presumably tax imports from other countries reciprocally at the same rate that U.S. products are tariffed in those countries. At least this is the general understanding. If this indeed happens, the prices of U.S. imports would jump higher very quickly and put pressure on government price indexes. If the European Union responds with its own tit-for-tat trade policy, inflation could get much worse there as well.
This could in turn force the Federal Reserve to hike interest rates faster than the new Fed Chair Jerome Powell may have wanted, which is exactly what is happening with his counterparts at the Bank of England right now. A rise in the price of imports plus a 63% increase in the dollar supply since 2010, together with a dramatic rise in the federal budget deficit for at least the next two years topping $1 trillion annually, could put tremendous pressure on interest rates in the U.S., and inflation as well.
It will be interesting to see what happens with inflation in the U.K. over the next few months, to say the least, with all of these factors percolating in the background in the U.S. and European Union.
Disclosure: Long GLD.
