PIMCO Bets on UK Inflation Decline

Pacific Investment Management Company (PIMCO), a major asset management firm, is wagering that inflation in the United Kingdom will decline, leading the Bank of England (BOE) to cut interest rates more aggressively than current market expectations. PIMCO believes the UK's price pressures are “not exceptional.”

The firm, which manages $2 trillion in assets, is overweight on 5-year UK gilts relative to the benchmark. These assets would benefit significantly from more aggressive rate cuts by the BOE.

“We don’t think the UK economy is going to be an extreme outlier [on inflation],” Andrew Balls, PIMCO’s global chief investment officer for fixed income, told the Financial Times.

Analyzing the Current UK Inflation Landscape

According to the Organisation for Economic Co-operation and Development (OECD), the UK is projected to have the highest inflation rate among the Group of Seven (G7) this year. The current inflation rate stands at 3.8%, proving stickier than many economists anticipated, partly due to sharp increases in food prices. Factors such as high energy prices and the lingering effects of Brexit also contribute to inflationary pressures.

Consequently, swap market traders currently anticipate the BOE will only cut interest rates once or twice by 25 basis points each by the end of next year from the current policy rate of 4%.

This puts the BOE in stark contrast to other major central banks. The European Central Bank (ECB) has already reduced policy rates from 4% in the middle of last year to 2%. The US Federal Reserve’s current policy rate range is 4%-4.25%, with expectations for at least four 25-basis-point rate cuts in the next 12 months.

Factors Supporting PIMCO's Outlook

Balls argues that slowing wage growth in the UK will help to pull down overall inflation. Additionally, one-off factors, such as “retailers passing on the labor costs of higher employer national insurance contributions,” will gradually fade.

“In our forecasts, the UK inflation picture improves next year, and we don’t think domestic price pressures in the UK are exceptional relative to other countries,” he added.

PIMCO's Rate and Inflation Expectations

PIMCO expects UK inflation to be near the BOE’s 2% target by the end of next year. Balls claims this would allow room for policy rates to move towards PIMCO’s estimate of the UK “neutral rate” – the rate that neither stimulates nor suppresses economic growth – which they estimate at 2.75%.

Last week, the BOE held interest rates steady at 4% while expressing concerns about inflation, warning that the “Monetary Policy Committee (MPC) judges that upside risks to medium-term inflation pressures remain significant when assessing the outlook.”

UK Chancellor Rachel Reeves told ministers in a cabinet meeting this month that they must join the fight against inflation, given the increasing cost-of-living pressures on households.

The November fiscal budget will be a crucial juncture. The government may introduce new taxes to fill a fiscal hole of over £20 billion, which could further fuel inflation.

“Market participants certainly have to watch the budget closely, and the impact of tax measures, such as tariffs and VAT, on inflation,” Balls concluded.