Three weeks today, on 11 May, the Bank of England’s Monetary Policy Committee (MPC) is likely to raise its main policy rate again.
Bank rate is expected to rise from the current 4.25% to 4.5% in what would be the twelfth consecutive increase since the MPC began tightening monetary policy in December 2021.
It will take Bank rate to a level last seen in October 2008.
Many people, chiefly small business owners and homeowners with mortgages, will have been hoping the Bank might hold fire next month.
But two pieces of data this week have given the MPC little choice.
Tuesday brought news that average pay, including bonuses, grew at an annualised rate of 5.9% during the three months to the end of February.
That was the same as in the three months to the end of January and ahead of market expectations. Forecasters had been expecting the rate of wage inflation to ease by now and yet it remains at elevated levels.
Then, on Wednesday, brought news that the headline rate of consumer price inflation fell from 10.4% in February to 10.1% in March. That, again, was ahead of market expectations.
The MPC said at its last rate rise, in March, that “if there were to be evidence of more persistent [price] pressures, then further tightening in monetary policy would be required”.
It now has that evidence.
A European and G7 outlier
Given the extent to which interest rates have been rising, many people will be puzzled as to why inflation has not begun to fall more rapidly, particularly with the UK now having the highest headline rate of inflation not only in the G7 but also in most of Europe.
Only a handful of European countries, mainly those in close proximity to Russia and Ukraine such as Hungary, Latvia, Lithuania, Estonia and Poland, now have higher inflation than the UK.
People may also, then, be wondering about the effectiveness of interest rate rises in dampening inflation.
There are several reasons why rate hikes are less effective in tackling inflation that was once the case.
Why interest rates aren’t effective as they used to be
The first is that the UK is emerging from a period, unparalleled in its modern history, during which interest rates have been set at close to zero and during which the Bank – like peers such as the US Federal Reserve and the European Central Bank (ECB) – engaged in asset purchases to stimulate economic activity (Quantitative Easing in the jargon).
It amounted to a gigantic economic experiment that created all kinds of distortions in the economy and fuelled inflation in any number of assets, most notably residential housing.
Unwinding that policy was always going to lead to unusual effects that were harder to predict. Those, it has turned out, included interest rate rises not having the impact on inflation that they have had in the past.
Pandemic impacts
Added to that, it can be argued, is the fact that, when inflation did begin to show up in economies around the world in 2021, central banks like the Bank, the Fed and the ECB insisted that it was “transitory” – a short term consequence of demand returning rapidly as economies emerged from Covid lockdowns and supply failing to keep up due to bottlenecks created by those lockdowns.
It is now very clear that this was not the case.
Central banks everywhere were slow to respond to the incipient threat of inflation and have had to over-compensate since with interest rates higher than would have been necessary had they responded sooner.
The Bank can argue, in its defence, that it was actually the first major central bank in the world to begin raising interest rates in the current cycle.
Some central banks, such as the Reserve Bank of Australia, were significantly slower to move – even though some, like the Fed and the Reserve Bank of New Zealand have since tightened more aggressively.
That, though, does not explain why inflation in the UK remains elevated compared with countries, such as many of those in the Eurozone, with lower interest rates and lower inflation.
The savings buffer
Another factor may be what has been happening to household indebtedness since the pandemic.
During the year from the start of the pandemic in March 2020, according to Bank of England data, British households accumulated some £192bn worth of enforced savings.
Much of that was used to pay down unsecured debts, such as personal loans and credit cards, or simply kept to one side.
It is very clear that not all of those enforced savings have yet been spent – and, accordingly, some consumers may be less responsive to higher prices than was once the case.
It certainly helps explain why consumer spending has been somewhat more resilient than might have been expected during the last 12-18 months or so in spite of inflation taking off. A lot of consumers seem content to pay the higher prices demanded by businesses selling them goods and services.
However, that again is a factor not unique to the UK, as it has been seen elsewhere.
So we have to look at other reasons why inflation does not appear to be responding to the Bank’s rate hikes so far.
One reason commonly offered for inflation being stickier in the UK than elsewhere is that the UK runs persistently high trade deficits – it consistently imports more goods and services than it exports.
A weak pound and importing more than exporting
That makes the country exposed to price increases around the rest of the world and especially given the weakness of sterling since the war in Ukraine began.
When Vladimir Putin attacked his neighbour, the pound bought $1.36, whereas today it will buy you $1.24. Similarly, when the war began, the pound bought €1.2037. It now buys just €1.1344.
So the trade deficit and sterling weakness is undeniably a factor.
Brexit and the labour market
Another factor unique to the UK is Brexit.
The tight labour market has contributed to domestically-generated inflation, as opposed to externally-generated inflation, of the kind seen in the prices of oil, grain and fertiliser as a result of the war.
Now, it is worth noting that Brexit has not ended migration to the UK (indeed, during the year to June 2022, net immigration to the UK hit a record high of 504,000), but it has changed the composition of the labour market.
Many skilled workers from the EU have returned home during the last six years, particularly around the time of the pandemic, which has created labour shortages and helped push up prices.
Another factor, which has again affected the UK more than many of its peers, is the contraction in the labour force since the pandemic. This is due to a combination of factors, including more over-50s opting for early retirement and an increase in the number of people dropping out of the jobs market due to long term sickness, but the impact is the same – it creates skills shortages.
That is going to particularly hurt an economy, like the UK, which is more heavily skewed towards services than many of its peers.
As the MPC member Catherine Mann has pointed out, the current combination of high vacancy levels and low unemployment rates is one that has not been seen in the UK labour market before.
It may help explain why inflation has not responded to interest rate rises as it did on occasions, such as the early 1980s, when unemployment was high and the number of job vacancies was low.
Fewer people impacted by rate rises
Another difference from the past is the changed nature of home ownership.
Many more Britons own their homes outright now than during previous periods during which interest rates rose – indeed, more Britons now own their homes outright than those who either have a mortgage or rent.
That means fewer homeowners, proportionately, are affected by interest rate rises than in the past.
At the same time, the majority of homeowners who still have a mortgage now have a fixed rate home loan, rather than a variable one.
In 2005, the last significant period of interest rate increases in the UK, some 70% of borrowers had a variable mortgage rate. That is down to 14% now.
Now it is true that, as people come off their previous fixed rate deals, they will see a rise in their mortgage payments. But it is undeniable that the changed nature of home ownership and of mortgages themselves means interest rate rises are not being transmitted through the economy as once was the case.
There has always been a time lag in how interest rates rises impact inflation. It seems that lag is now longer.
And that, in turn, raises the danger for the MPC of over-tightening.
Whether the MPC has over-tightened, though, will only become clear over time.
