High debt meets high inflation, and the UK is in trouble

Inflation pressure is most severe among major developed economies, with a significant increase in the government debt-to-GDP ratio, and the UK economy will face major troubles: the central bank's further room for interest rate cuts is narrowing, and large-scale tax increases are almost inevitable.

On September 4th, according to news from the Wind Trading Desk, Nomura Securities stated in its latest research report that the UK's inflation rate reached 3.8% in July, far exceeding other developed countries, while the inflation rate in the service sector soared to 5.0%, influenced by multiple factors such as the depreciation of the pound, weak productivity growth, and imbalanced wage growth.

The analysts warned that this persistent inflation issue may not only force the Bank of England to pause its interest rate cuts but will also further exacerbate fiscal pressure.

The report pointed out that the combination of high inflation and high debt levels is intensifying the fiscal pressure in the UK. Since the global financial crisis in 2007, the increase in the UK government's debt-to-GDP ratio has surpassed that of all other major developed economies, including the United States.

Nomura Securities indicated that the current yield on 10-year UK government bonds has risen to 4.80%, reaching a new high since the peak in January, and the increase in debt interest payments will force the Chancellor of the Exchequer to raise taxes in the upcoming autumn budget.

Inflation Stickiness Reaches Highest Among Developed Economies

Data from the UK Office for National Statistics shows that the CPI rose by 3.8% year-on-year in July, exceeding market expectations by 0.1 percentage points, while the inflation rate in the service sector reached 5.0%, exceeding expectations by 0.2 percentage points.

This marks the fourth consecutive month that inflation data has exceeded expectations, and the eighth consecutive month that the market has failed to accurately predict the UK's inflation trend. Nomura analyst George Buckley pointed out:

All components of UK inflation—food, energy, core goods, and service prices—are currently higher than those in the Eurozone and the United States. Although some special factors have driven up inflation, including significant increases in water and sewage treatment fees, fluctuations in air ticket prices, and the rise in vehicle consumption tax in April, even excluding these factors, the UK's inflation rate would still be the highest among G7 countries.

From a historical perspective, high inflation in the UK is not a new phenomenon. Data shows that not only in July of this year but also in terms of the average annual inflation rate since the pandemic and the ten-year average inflation rate from 2010 to 2019, the UK ranks first among the G7.

Nomura Securities also stated that although the average inflation rate in the UK from 1997, when the central bank became independent, to the pre-pandemic period in 2019 was exactly at the target level of 2.0%, the current inflation stickiness and policy dilemma indicate that the UK economy is facing one of its most severe challenges in recent years.

Multiple Factors Driving Up Inflation Pressure

Analysts believe that the causes of inflation stickiness in the UK are complex and varied.

Weak productivity growth and imbalanced wage increases are key issues.

In the 2000s, the average annual productivity growth in the UK was only 1.0%, dropping to 0.7% in the 2010s, and since the 2020s, it has been merely 0.5% More critically, the wage growth in the UK is too strong relative to weak productivity growth.

Since 2020, the annual growth rate of unit labor costs in the UK has averaged 5.1%, significantly higher than the 3.7% in the Eurozone. Catherine Mann, a member of the Bank of England's external monetary policy committee, also mentioned the rising inflation expectations and the "unexplained strong" wage growth issue in a recent article.

The depreciation of the pound is also an important factor driving up inflation.

Since its peak at the end of 2007, the pound has fallen by more than one-third against the dollar, a decline greater than that of the euro against the dollar during the same period, while the UK's exposure to international trade (as a percentage of GDP) is larger.

The impact of Brexit cannot be ignored either.

The proportion of UK trade flow to GDP has significantly decreased since Brexit, which may lead to rising supply chain costs and industrial repatriation, thereby pushing up domestic prices and wage levels. The Office for Budget Responsibility (OBR) estimates that compared to being an EU member, the trade agreement with the EU will result in a long-term loss of about 4% in productivity for the UK.

Monetary Policy Faces a Dilemma

The stickiness of inflation is reshaping the Bank of England's policy considerations. Nomura Securities maintains its expectation of two 25 basis point rate cuts (in November and February next year), but emphasizes that this forecast is "highly dependent on the specific evolution path of economic data."

Nomura stated that, given the official interest rate is close to what the central bank considers the neutral range, any further upward movement in inflation data could lead the central bank to pause or completely halt rate cuts. The central bank may also maintain its quantitative tightening plan of £100 billion per year.

Catherine Mann, a member of the external monetary policy committee, emphasized in a recent speech that "if policymakers are uncertain about the persistence of inflation, it is appropriate to respond actively to inflation."

It is noteworthy that there are two more CPI data releases on September 17 and October 22, which will become key observation windows before the November central bank meeting. Any further upward movement in inflation data could completely dispel market expectations for the central bank's easing policies.

High Debt Intensifies Fiscal Challenges

The combination of high inflation and high debt is significantly exacerbating the fiscal pressure in the UK. Since the global financial crisis in 2007, the increase in the ratio of UK government debt to GDP has surpassed that of all other major developed economies, including the United States, which may support the so-called "price level fiscal theory."

Nomura believes that the surge in debt interest burden is the main threat. The yield on 10-year UK government bonds is currently at 4.80%, a new high since January, while the 30-year yield has risen to its highest level since the late 1990s. Under the dual blow of high inflation and high yields, debt interest expenditure has significantly increased.

Other fiscal pressures include:

The OBR is overly optimistic about economic growth (with a growth forecast of 1.9% for 2026, while Bloomberg's consensus forecast is only 1.2%); the failure of the welfare bill has resulted in a £5 billion annual spending cut being scrapped; the government needs a larger fiscal buffer than the previously announced £9.9 billion.

Nomura Securities believes that the impact of high inflation on fiscal policy is more direct and severe. In the upcoming autumn budget, Chancellor Rachel Reeves faces multiple pressures for tax increases