UK bonds signal recession as inflation bedevils Bank of England's response

The UK just got its biggest recession warning since the global financial crisis, yet the Bank of England also got a reminder of how difficult its job might be in responding.

In a so-called yield curve inversion, a typical harbinger of economic contraction, the yield on 10-year government debt fell below the 2-year equivalent on Wednesday for the first time since 2008. A couple of hours earlier, the statistics office reported that inflation unexpectedly accelerated above the BOE’s 2 per cent  target -- and worse could be to come as a plunge in the pound filters through to prices.

The developments reinforce the repeated message from Governor Mark Carney and his colleagues that they won’t necessarily be able to soften the blow of a downturn with a cut in interest rates. Unlike much of the rest of the developed world, British price rises are being pushed upward by a combination of tight labor markets and a weakening currency. The increasing likelihood of a no-deal Brexit that constrains supply would add to the momentum.

"Everything is moving in the wrong direction for the Bank of England to perhaps sit quite as comfortably as they otherwise would have done,” said Victoria Clarke, an economist at Investec in London. “Sitting tight on rates is now becoming a bit less comfortable because the global economic backdrop looks to have weakened and some of those forces, those headwinds, are showing no signs of abating."

The yield curve inversion reflects global economic woes as trade tensions weigh on confidence and demand. The US yield curve also inverted on Wednesday, for the first time since 2007, and China, Germany and the euro zone all reported weak data.

BOE policy makers are widely expected to keep interest rates on hold until the nation’s exit from the European Union is resolved. Economists still expect a rate cut if Britain crashes out on Oct. 31 without a deal, though that could require the bank to allow above-target inflation.

The acceleration in consumer-price growth to 2.1 per cent last month was boosted by computer games and hotel accommodation. Economists had expected it to slow to 1.9 per cent.

In another sign of pain, the retail prices index climbed 2.8 per cent. That’s important for rail commuters as regulated fare hikes, which cover around 40 per cent of all fares, are capped based on the July reading. Any increases will come into effect in January.