It has been a week where the theme of interest rates being ‘higher for longer’ has been at the top of the agenda
This has somewhat dampened the market mood after a strong recent run. The focus has very much been on the UK, with inflation data once again surprising to the upside, and the Bank of England hiking rates for the 13th consecutive meeting, with market pricing now indicating rates will top 6% by the end of the year.
The UK inflation data for May showed CPI at an unchanged level of 8.7% year on year; the consensus was for inflation to ease to 8.4%. This was the fourth month in a row where inflation was higher than forecast. Core inflation, which excludes food and energy prices, increased in pace from 6.8% in April to 7.1% in May, the highest rate for 31 years. The Financial Times noted this continued climb in core CPI is an outlier against international peers with CPI flat or declining in 28 of the 35 major economies for which they track data. The pace of food and non-alcoholic beverage price rises slowed slightly but was still up 18.4% year on year. There was some positive news, with PPI data (also known as factory gate prices and a reliable leading indicator) showing a slowing in pace to 2.9% year on year. This has slowed from a peak of 19.6% last July. We should also remember that in the coming months the significant drop in energy prices will positively impact the data. All the same, the UK data has not eased in line with other developed markets. Using the same methodology, the comparable CPI data for May shows the UK at 8.7%, the eurozone at 6.1% and the USA at 2.7%.
The widening gap between UK inflation and rates in the US and eurozone is reinforcing market perceptions that the UK has a structurally higher inflation rate than other developed markets. Looking back to 1970 UK inflation has averaged over 5% and even in the disinflationary decades of the 2000s and 2010s UK inflation slowed to only 1.9% and 2.1%. This highlights that the Bank of England’s 2% target not easy to achieve and indeed if the Bank does want to bring inflation down to these levels significant amount of economic pain will be required. It does feel like some UK consumers are about to learn a tough economics lesson, not really seen since the early 1990s (arguably the last ‘normal recession’ we saw – but a distant memory for a lot of households). Ultimately interest rates are a blunt instrument but are the most effective tool at slowing economic activity. However, this means some pain – and on top of recent energy and food cost increases, the cost of borrowing for households is shifting higher from the ‘abnormal’ levels of the past decade or so as the Bank of England hikes interest rates.
We have seen an increasing number of news stories in the mainstream media surrounding mortgages in the UK and while a far lower proportion of households now have a mortgage compared to the early 1990s, at around 30% of households, the level of debt is significantly higher. With many mortgage rates having been fixed below 2.5% now we’re likely to see refinance rates closer to 6%. So, there will be pain to come for borrowers but this will also extend to rentals as a result of higher mortgage payments for their landlords being passed on in the form of higher rents. While we can take some comfort from the number of households with a mortgage being lower than in the past, the bulk of mortgages are held by the demographic with a higher propensity to spend, and with the UK economy seeing anaemic growth at best, the probability of tipping into recession later this year or in early 2024 is increasing.
Yesterday saw the Bank of England surprise markets with a 50 basis point interest rate rise, taking rates to 5%, a level last seen in 2008 before the financial crisis. The Monetary Policy Committee voted 7-2 for a larger rate hike than the 25 basis point hike anticipated by the market, though after the inflation data on Wednesday the rationale behind the more aggressive policy move was clear. Policy makers said nothing to dampen market expectations that rates could be over 6% by early next year with Governor Andrew Bailey stating “bringing inflation down is our absolute priority. The MPC will do what is necessary to return inflation to the 2% target”. The meeting minutes noted that “second-round effects in domestic price and wage developments are likely to take longer to unwind than they did to emerge” and warned of “more persistence in the inflation process against a backdrop of a tight labour market and continued resilience in demand”. Despite the rate hike, the Bank noted that inflation pressures will soon ease, highlighting the fall in the PPI data, and expected falls in food price inflation. The Bank said “consumer price inflation is expected to fall significantly during the course of the year”.
So why the aggressive rate hike? The Bank would argue that these moves are needed to avert a wage-price spiral emerging where inflation continues even as the original catalyst for the inflation (food and energy price shocks) fade from the data. Governor Bailey said in the press conference yesterday that the current level of wage increases “cannot continue”. With further rate hikes anticipated, the policy stance from the Bank will likely become more controversial, not least because UK consumers, and politicians, have such little experience of a high rates environment. Looking forwards, markets are pricing a 91% probability of rates at 6.25% at the peak early in 2024; levels that seem unimaginable just a few years ago. Having failed to see inflation being persistent rather than transient, the Bank of England has a tough task ahead in balancing the need to bring down inflation without causing too much economic harm, and at the same time trying to keep some credibility amid increasing political and media scrutiny.
