The President of the United States, in a characteristically unorthodox turn of phrase, has described rising inflation as “lovely” as his administration grapples with the aftermath of massive fiscal stimulus. Across the Atlantic, the British economy is showing remarkable resilience against price pressures, with core inflation holding steady at 3.2% in February, defying expectations of a sharper uptick. The divergence in rhetoric and reality between the two economies tells a story of market discipline versus political expediency.
Donald Trump’s comment, delivered during a Cabinet meeting, was met with raised eyebrows in financial circles. “Inflation is a beautiful thing when it’s under control,” he said, apparently referring to the 1.9 percentage point rise in the US consumer price index since the start of the year. But for bond markets, this is anything but lovely. The ten-year US Treasury yield has surged to 1.75%, a level not seen since before the pandemic, as investors price in a faster pace of tightening from the Federal Reserve. The US fiscal deficit, now running at over 15% of GDP in the first quarter, is fuelling a consumption boom that has importers straining to keep shelves stocked.
Yet in London, the tone is markedly different. The Bank of England, under Andrew Bailey, has maintained a cautious stance, keeping the Bank Rate at 0.1% while resisting the urge to expand quantitative easing further. The result is a bond market that, while not entirely placid, is far less volatile than its American counterpart. The yield on the ten-year gilt has risen only modestly, to 0.85%, reflecting a market that believes the MPC will not be rushed into rate hikes. Headline CPI may have jumped to 2.5%, but the BoE has repeatedly stressed that this is transitory, driven by base effects from last year’s lockdown.
What explains this divergence? In short, the UK’s twin deficits are far smaller than America’s. The current account deficit is around 3% of GDP, manageable by historical standards, and the fiscal deficit is expected to narrow sharply as the economy reopens. The US, by contrast, is running a current account deficit of over 4% and a fiscal deficit that the Congressional Budget Office projects will remain above 5% for the next decade. Capital is flowing out of dollar assets and into sterling, a vote of confidence in UK fiscal discipline.
But this is not a time for complacency. The risk of imported inflation through rising energy prices remains acute. The UK is a net importer of energy, and the recent spike in oil prices to $70 a barrel will eventually feed through to household bills. More worrying is the threat of capital flight if the market loses faith in the BoE’s commitment to price stability. The central bank’s forward guidance has been deliberately vague, leaving investors to second-guess the reaction function. A sudden spike in inflation expectations could force the MPC into an abrupt tightening cycle, choking off the recovery.
The irony is that Trump’s ‘lovely’ inflation is exactly what the world economy does not need. The US economy, already running hot, could overheat, forcing the Fed to slam on the brakes. That would be bad news for emerging markets, which are already feeling the pain of higher US yields. For the UK, the focus must remain on avoiding a sell-off in gilts. The Treasury’s fiscal plans will be crucial; if the Chancellor uses the next Budget to announce tax rises that do not hit growth, the markets will reward him. If he caves to pressure for more spending, the gilt market could revolt.
In the meantime, the British public should be grateful that their central bank and government have, for now, avoided the kind of fiscal incontinence that is creating headaches in Washington. The price spiral may still come, but for the moment, the UK is holding firm. Whether that remains the case depends on whether policymakers can resist the temptation to copy Trump’s ‘lovely’ approach to inflation.
