You might have read that government interest rates are (almost) back to Trussian levels https://www.bloomberg.com/news/articles/2023-05-24/traders-bet-on-boe-rate-peaking-at-5-5-after-inflation-surprise, which could mean that the Bank of England would need to raise interest rates to 5.5% later in the year.

Rising Two-Year Gilt Yields

Two-year gilt yields, a key measure of government borrowing costs, are currently at 4.56 per cent—the highest level since the turmoil that followed the disastrous mini-Budget of Truss and Kwasi Kwarteng last year—and will probably surpass that threshold soon. A year ago, they stood at less than half of that at 2.048%. So why is interest on gilts so high?

First of all, gilts are bonds issued by the UK government, so the higher interest rates are not being set by the Bank of England (yet), but gilt yields give a good indication of what to expect. Gilts are auctioned regularly, so their interest rates give a very good indication of where interest rates will go, as higher risks will lead to higher interest rate payments being demanded. The obvious answer is inflation.

Persistent High Inflation in the UK

Inflation in the UK is still quite high, and it is higher than in other countries. Official figures showed inflation in the UK fell to 8.7 per cent in April, from 10.1 per cent in March and a peak of 11.1 per cent last year. But it was still above the 8.2 per cent pencilled in by investors, and so-called ‘core’ inflation—which strips out energy prices—jumped from 6.2 per cent to a 31-year high of 6.8 per cent. German inflation fell sharply in May. Prices there rose by 6.3% over the latest 12 months, down from 7.6% a month earlier (measured by the harmonised index of consumer prices, which is comparable across countries). On the same measure, inflation in France, the eurozone’s second-largest economy, also slowed to 6%, its lowest level in a year; economists had predicted 6.4%.

Understanding Inflation Rates

While inflation rates have decreased, it is really important to note that this does not mean falling prices. It just means that prices are accelerating more slowly than before, but they are still rising. The prime minister’s goal of halving inflation would still leave us at a high level compared to the past 18 months. Expect to hear a lot of misinterpretation after the summer when politicians are slowly starting to warm up for the general election.

There are also technical reasons for lower inflation—one is rebasing. Inflation is usually measured on a year-on-year comparison. If there has been a sudden spike in prices which plateaus afterward, inflation will look lower a year after that, but the price increase is still felt. You will remember that gas (and other energy) prices shot up by up to ten times after Russia invaded Ukraine. Inflation is measured against a basket of goods and services which should reflect what an average customer buys. This usually works well but could create issues in times of very high inflation, as this basket will change too quickly to keep pace (spending more on food, so you have less money for digital gadgets). It might not capture shifts in demand, e.g., if consumers continue to buy the same goods but change their shopping habits, e.g., switching from Waitrose to Lidl.

Core vs. Non-Core Inflation

The most commonly used indicators measure non-core inflation, which excludes more volatile prices, e.g., for food (strawberries will be cheaper in the European summer than in the winter) and energy. This makes sense, as inflation would be too volatile for longer time series. Unfortunately, food and energy prices influence a big part of consumers’ personal/discretionary spending (more on that below). Sometimes, you will also see the term “perceived inflation”: these are price increases that are visible but do not matter that much to the overall economy, e.g., the price of a pint of beer or your morning coffee. It could also mean that prices jumping over a threshold are perceived as higher inflation, e.g., the price of a pint going from £5.90 to £6.00 feels like a bigger jump than going from £5.80 to £5.90, although it is the same increase (leaving aside a small difference in percentage). However, prices in UK stores are rising at a record pace as the cost-of-living crisis shows little indication of easing. Shop price inflation accelerated to 9% last month, a new peak for an index by the British Retail Consortium. The ONS put the figure for food price inflation at 19%, close to the highest rate in more than 45 years. This is a double blow: very high rises in prices on daily spending (we all need to eat) can reduce spending in other areas—you might have heard the term shrinkflation: inflation with an economy in recession which means that you cannot outgrow inflation. Increases in food are also quite visible in daily spending and will increase the perception of rising prices/a higher rate of inflation than actually measured.

Why Central Banks Target 2% Inflation

If this is all so bad, why do many central banks have a target of 2% inflation rather than 0%? As you have seen above, inflation is hard to measure, and even if you can measure it, it often comes with a time lag, so not ideal for policymaking. Moderate inflation is also good for overall growth—would you make an investment with zero growth? Probably not. The 2% target is a compromise of being close enough to zero to have stable prices, but providing enough stimulation for growth at the same time.

Reasons for Hope

There are reasons for hope, though. Prices for natural gas in Europe have tumbled from over €300 ($324) per megawatt hour last summer to €30 in recent days. That is high, but back within the normal historical range. While energy prices are not part of the core inflation, companies will try to pass them on to their customers, and employees will ask for higher salaries to offset higher energy costs, fueling inflation. On top of that, salary negotiations take expected inflation into account, so if these expectations fall, salary demand will be reduced as well.

Interest Rates on the Rise

Now back to interest rates. They are clearly on the rise across the major economies. In early May, the yield on two-year US Treasuries, which is especially sensitive to expectations of the Fed’s policy rate (similar to two-year gilts), fell to 3.75%. It has since increased to 4.4% as officials briefed journalists that they were contemplating raising rates further than their present level of 5–5.25%. Traders in futures linked to interest rates, who were until recently anticipating US rate cuts within a couple of months, have also switched to betting on another rise. The return of rising rates feels more ominous for investors. True, part of the story is that the economy has held up better than expected at the start of the year, and most certainly better than feared once banks began to get into trouble. Yet the bigger part of the story is that inflation has proved unexpectedly stubborn in the US as well. As of April, core American inflation was at 5.5% year on year. Although recession has been avoided or at least delayed in the US, few are predicting stellar growth. In these circumstances, rising rates are bad for stocks and bonds. They hurt share prices by raising firms’ borrowing costs and marking down the present value of future earnings. Meanwhile, bond prices are forced down to align their yields with those prevailing in the market.

Impact of Interest Rate Differences Between Countries

Differences in interest rates between countries can also distort flows of investments. Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.

Looking Ahead

So, we will have an interesting 12–18 months ahead of us. Financing companies and deals will be more expensive (and hence more selective). The pressure on returns will increase, as investors will want to beat inflation, so are asking for higher returns. There will be demand for higher salaries, and employees might vote with their feet, which can further distort the economy—just look at the current strikes of teachers, nurses, and train staff. If they decide to leave for greener pastures, these services will deteriorate or eventually collapse.