The fear of inflation acceleration in the UK as Brexit approaches
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The fear of inflation acceleration in the UK as Brexit approaches

In the face of a high degree of political uncertainty surrounding Brexit, UK asset markets have remained relatively stable.

The pound has slightly weakened since the initial devaluation brought about after the 2016 referendum. In furtherance, there has been no crash in asset prices such as the 1976 IMF crisis, the 1992 European Exchange Rate Mechanism and the 2008 financial crash.

Nonetheless, there has been significant increases in concern relating to inflation risks surrounding the UK asset market. As the market absorbed the inflationary impact derived from the 20% pound devaluation, the UK inflation rate risen by a full percentage point in June 2016. Moreover, as soft Brexit seemed to be probable in 2017, the inflation rate fell marginally but has risen by about 0.6% since March.

Although the rise in the UK inflation rate appears limited, the major concern is that the surge in the inflation occurred within a period where by the inflation rate in other major economies has declined due to oil price crashes. In comparison to the US, the UK inflation rate has risen by 0.8% since last summer.

It is critical to identify why the inflation scenario in the UK have worsened. Of note, the increase in the inflation rate has outperformed the increase in consensus economic forecasts for UK inflation over the same period.

It is therefore critical to note that such change has been brought about by an increase in the inflation risk premium and not by a shift in the UK inflation expectations, thus raising concern relating to the tail risk of a higher inflation rate.

There are numerous reasons as to why such tail risk has recently risen. Keeping in mind that the UK labour market is extremely tight and the wage inflation is above the 2% inflation target, the imposition of hard Brexit would result into a continued sterling devaluation.

A hard Brexit may also result into continued problems relating to public borrowing and fiscal sustainability in the UK. Due to the recent episodes of high inflation rates in Britain, UK inflation expectations are not as well anchored as they are in the US, Eurozone and Japan. The latter thus contributes towards a further increase in tail risk.

Although the above-mentioned scenario does not demonstrate a pleasant constitutional situation within the UK, it is important to emphasise that this has not yet developed into an economic or financial crisis.

However, the increased level of concern relating to the possible implementation of a hard Brexit, together with consequences derived from the tight labour market and the macroeconomic policy are all contributing towards a hike in inflation risk.

This article was issued by Andrew Fenech, Research Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

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