Trying to bring inflation down, the Bank of England has hiked interest rates a dozen times since late 2021 yet price rises in the UK are continuing to outstrip those in other countries.
Figures this morning showed inflation rose 8.7% in May, the same as April, confounding the forecasts of the BoE’s monetary policy committee (MPC) and its mission to keep CPI at around 2%.
For the UK it was the second month in a row where inflation has surprised by remaining stubbornly high, even though the MPC and many economists predict it should be starting to fall more sharply.
While some other countries have seen some unwanted blips, the main contrast is that inflation in almost all other major economies is much lower: US headline CPI was 4.0% in May, 4.4% in Canada, 6.1% in Germany, 5.1% in France and 3.2% in Spain.
Further marking the UK out from other advanced economies, core inflation increased to a 31-year high of 7.1% last month.
In the US and Germany core CPI softened the last two months, easing to 5.3% and 5.4% respectively last month.
As a result, expectations have solidified for the MPC to lift rates some way above the current 4.5%, with tomorrow’s meeting now expected to see at least see a hike to 4.75% and possibly to 5.0%.
Markets are also hardening expectations that UK rates will peak at around 6.0% this winter.
Why is Britain’s inflation different?
“UK inflation is different - and not in a good way,” said strategist Joachim Klement at Liberum.
He said this morning’s numbers are “not about energy or food inflation – transitory shocks that are more easily managed through institutions – but rather about a more structural, long-term problem related to low productivity and a tight labour market.”
A major driver of the UK’s CPI exceeding other countries is services inflation, which is given a higher weight in our inflation basket than the US and the eurozone.
“The Bank of England is most focused on services inflation because it tends to exhibit more persistent and less volatile trends,” says economist James Smith at ING.
“Crucially”, he says, the upside surprise over the MPC’s forecasts, “doesn’t appear to be concentrated in any single category”.
Moreover, recreation (those Beyonce and Taylor Swift concerts you’ve read about) is 14% of the CPI basket in the UK, compared to 8% in the eurozone and 3% in the US.
“There are several factors at play,” says Neil Shearing, chief economist at Capital Economics, “but an important one is that inflation appears to have infected the labour market and wage setting to a greater extent in the UK than elsewhere.”
What has made it worse is the coincidence of the energy shock with the UK labour force seeing a bigger and more persistent shortfall, a number of economists said.
Part of that is due to Brexit and part is due to a rise in long-term sickness since the pandemic, says Klement.
“As a result, wages have tracked inflation closely as firms avoid the troubles and costs of hiring new personnel, which has ultimately pushed services inflation higher,” he said.
Energy price inflation in the UK has been slower to fall, with the regulator’s price mechanism meaning that the more recent fall in wholesale gas prices is taking longer to lower utility bills.
How the MPC’s hikes affect the economy has changed dramatically due to shifts in the mortgage market in recent decades, says Holger Schmieding, chief economist at Berenberg.
As the UK has more fixed-interest mortgages, the pass-through of monetary policy to consumption via the housing market takes longer than in the past, he explains.
Only 30% of households currently have a mortgage and just 7% of the loan stock is refinanced every quarter, points out Samuel Tombs, chief UK economist at Pantheon Macroeconomics.
“But many borrowers also are lengthening the term of their mortgage when they refinance in order to limit the jump in monthly payments,” he says, with the result being that regular mortgage payments have remained “remarkably stable”.
What can the BoE do?
Schmieding says the pass-through will still happen and consequently sees the market pricing 6.0% rates “looks too high to us".
Chris Clothier, fund manager at Capital Gearing Trust, pointed out that leading indicators are beginning to show the labour market cooling, and the impact of interest rate rises is starting to be felt on mortgage rates as mortgage holders come to the end of their fixed terms.
“We expect that this will eventually depress demand which, combined with energy and food inflation moderating, will eventually control inflation,” he said.
But Downing Street is reportedly putting pressure on banks to go easy on households.
With an announcement plausibly coming as early as Friday, Citi economist Benjamin Nabarro said the government “can exert considerable pressure on the banks” via threats on taxation or reserve remuneration.
“With more homes owned outright, the main impact would likely be to slow transmission from interest burdens to house prices. With more homes owned outright, that may prove significant.”
Given the immediate inflationary challenge, Nabarro said he sees risks that “for the second time in 12 months” the government seems at risk of pushing the UK further from the “optimal policy mix”.
While the effect of the rate hikes is not the same as it once was, Tombs says further sharp increase in new mortgage rates will “hit house prices hard, weighing on residential investment and consumers’ confidence […and…] businesses will seek to reduce staff costs and investment in response to the huge, sudden rise in their financing costs”.
A recession will be avoided, he thinks, but the economy will recover only sluggishly over the coming quarters.