The UK faces a serious inflation issue if oil pops!

Bond markets are pricing in rate hikes this year by the ECB and the BoE. Both are inflation targeters, so which one should react first to a possible spike in oil prices? What’s your answer?

(1) Neither. As FX appreciation and fiscal austerity pass through to domestic prices, the core will drag down the headline. If they hike, stagflation will result.

(2) The ECB, because it is the most hawkish of all central banks, in my view. The ECB mandates a rigid targeting scheme compared to that of the BoE. Since the January 2005, the BoE has successfully targeted inflation slightly under 2% just 27% of the time, while ECB has done so 61% of the time.

(3) The UK. The January 2011 UK inflation rate was 4% Y/Y (3.2% in November on a harmonized basis) and near-double that in the Eurozone, 2.4% according to the flash estimate.

Furthermore, the UK story is not one of just energy and food. The chart below illustrates the diffusion of price inflation across the components of the harmonized HICP (data at Eurostat), and the legend lists the period average for each economy. Diffusion levels above 50 indicate that a larger share of component prices are growing at an annual rate above 2% that below 2%. The diffusion a measure of the breadth of price pressures…

…and is UK inflation broad-based! In contrast, inflation in the Eurozone is focused in the commodity and energy space. Now, I’m not suggesting that the BoE hike – in fact I would recommend the opposite, or at least stay on hold – but I’m sure that the BoE has its vision acutely focused on developments in the Middle East.

If I had to choose an economy that would be derailed by the price spikes in the commodity space, it would be the UK. But I choose (1).

Rebecca Wilder

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