How high will rates go?

The inflation figures the UK reported on Wednesday were not just objectively bad, with prices rising just as fast as a month before.

They also come at a supremely sensitive time, with the Bank of England meeting to decide interest rates and mortgage costs an issue of nationwide concern.

If the central bank is true to its word, it is bound to raise rates on Thursday. The only question is how much higher they have to go.

The BoE said after its meeting on May 11 that the Monetary Policy Committee would increase the cost of borrowing further, “if there were to be evidence of more persistent [inflationary] pressures”.

According to almost all economists, that test has been passed. Since the meeting in early May, official figures for April showed a sharp rise in core inflation — which excludes items such as food and energy where prices are generally more volatile — from 6.2 per cent to 6.8 per cent.

The measure then rose further in May to 7.1 per cent. Over the same period, core inflation was flat or declining in 28 of the 35 countries tracked by the Financial Times.

The BoE had not expected a significant rise in such underlying measures of inflation and it thought the headline rate would drop to 8.3 per cent by May. In the event, it remained at 8.7 per cent.

Even more troubling for the BoE are signs that wages and prices are rising in tandem, making inflation harder to eradicate.

The latest annual regular wage growth of 7.2 per cent was far above the level that the BoE thinks consistent with meeting its 2 per cent inflation target. With productivity growing at best at 1 per cent a year, wage growth will need to drop to about 3 per cent before the BoE feels comfortable with persistent inflationary pressures.

The new information since the MPC’s last meeting means the BoE will need a tough message on Thursday, economists said.

Martin Beck, chief economic adviser to the EY Item Club, said, “The MPC’s criteria for further rate rises appears to have clearly been met,” adding that a half point rise on Thursday was “now not out of the question”.

Economists generally think the BoE will raise rates by a quarter point this week but might opt for a larger rise in August, bringing the benchmark rate from 4.5 per cent now to 5 or 5.25 per cent by midsummer.

Such is the seriousness of the UK’s plight that some central bank watchers think the BoE will have to be much more forceful, at least with its communication on Thursday.

Krishna Guha, vice chair of Evercore ISI, said that the BoE now had to “stamp out” the second-round effects of a ratchet between higher wages and prices that was “uncomfortably visible in the data”.

Although he said the BoE might not ultimately need to raise rates higher than 5.25 per cent, he argued that the central bank should make it clear it was going to squeeze the economy hard in the months ahead to prevent inflation sticking at high rates even longer.

Financial markets are suggesting an even tougher path ahead than economists. Traders expect interest rates to climb to 6 per cent by the end of the year before they begin to fall back.

One problem with such predictions is that neither economists nor financial markets have been correct so far in this inflationary cycle.

Both groups have substantially revised higher their predictions of the peak interest rate over the past 18 months.

At the start of 2022, traders thought interest rates would peak at 1.25 per cent and a year ago they expected the cost of borrowing would not rise above 3.5 per cent.

With inflation more ingrained into daily life in the UK than in the US or the eurozone, rates are now expected to stay higher than elsewhere. UK interest rates are now forecast to rise above those in the US later this year.

For the 7.5mn households with a mortgage, the interest rate outlook is turning into what politicians are calling a “ticking time bomb”, because most face large increases in repayments as their fixed-rate deals come to an end.

Some 1.6mn who need to move to a new fixed rate in 2024 will face increased payments averaging £2,900 a year, according to the Resolution Foundation, a think-tank.

The BoE is aware of the hardship caused by interest rates, which squeeze the economy until households cannot afford to spend as much or will not accept price rises in shops.

Catherine Mann, the MPC member who has been most concerned about high inflation, maintains this is the necessary process of bringing inflation down towards reasonable levels.

Speaking to MPs last month, she said the BoE needed to make life sufficiently tough so that consumers prevented companies raising prices. “[Inflation] becomes a reinforcing dynamic until consumers boycott and say, ‘I cannot’, because of the purchasing power or cost of living, or, ‘I will not pay that high price’,” Mann added.

The danger of a rapid further rise in interest rates, however, is that the BoE goes into overkill mode, creating a recession and more pain than is necessary. That point is difficult to judge in advance because the effects of interest rates on inflation are generally thought to take at least 18 months to work through the system.

So far, the evidence from the BoE’s own forecasts on the persistence of inflation is that it has done too little too late to control inflation. That means it has a more difficult inflation problem to resolve than it and most analysts previously thought.

Source: Economy - ft.com