A recent spike in attacks on shipping in the Red Sea is beginning to have a noticeable impact on British companies, as they report a significant rise in the prices they pay for goods. This disruption to supply chains has the potential to boost inflation and could potentially delay interest rate reductions in the UK. The latest data from S&P Global's Composite Purchasing Managers' Index shows the sharpest increase in costs in five months, accompanied by longer delivery times for the first time in a year. Additionally, a survey by the Confederation of British Industry reveals that average costs for manufacturers have accelerated in the first quarter of the year, with further price rises expected in the coming months.
These reports provide tangible evidence that the Red Sea conflict is beginning to seep into the UK economy, leading investors to reconsider their expectations of how quickly the Bank of England can cut interest rates. As a result of this news, the pound experienced a surge, and markets have adjusted their predictions to a slower pace of rate reductions.
While the S&P survey indicates that the UK may avoid a recession, concerns over supply chain issues remain. Stronger activity and upward pricing pressures raise doubts about how soon the Bank of England will shift its focus from combating inflation to promoting economic growth through lower interest rates.
The persistence of price pressures in the services sector is likely to concern the Bank of England, as noted by Ashley Webb, UK economist at Capital Economics. This stickiness in prices reduces the confidence that services CPI inflation will return to its long-term average of 3.5% by the end of the year. Consequently, the Bank will probably continue to resist the prospect of near-term interest rate cuts.
With the release of these reports, the pound strengthened, and gilts pared their losses. The yield on the 10-year gilt, which had initially fallen by 5 basis points, is now on the brink of rising above 4% for the first time since December. Furthermore, the probability of a rate cut in May has diminished, with the June meeting now seen as the most likely moment for the first reduction.
These surveys highlight the impact of the recent attacks on ships by Houthi militants in Yemen's Red Sea. Companies have been forced to redirect deliveries around the Cape of Good Hope instead of using the Suez Canal, resulting in longer delivery times and increased costs. These disruptions are among the earliest concrete indications that the Red Sea conflict is impacting the UK economy.
The potential chaos in supply chains could prove to be a setback for the Bank of England, hindering its efforts to bring inflation back to its 2% target. While economists anticipate inflation reaching the target in the spring, the attacks on shipping may drive up the prices of goods and reignite inflationary pressures. To restore calm to the shipping artery, US and UK forces have recently targeted Houthi installations.
According to S&P's report, the rate of inflation in the manufacturing sector has reached its highest level since March 2023 due to the surge in ocean freight rates. Additionally, factories are experiencing longer vendor delivery times after an 11-month period of improvement. S&P warns that inflation may remain stubbornly higher in the 3% to 4% range in the near future.
Looking ahead, this disruption to global supply chains serves as a reminder of the impact it can have on inflation and central banks. George Moran, an economist at Nomura, states that the disruption poses upside risks to inflation further into 2024, albeit with long-lags.
Despite concerns over inflation, the S&P composite PMI rose to 52.5 in January, its highest level in seven months. This indicates continued resilience in the services industry, and overall private sector employment has also seen a positive trend, ending a four-month period of job losses.