For much of this year, the Bank of England (BoE) has been telling us that the long run of interest rate rises was coming to an end. But economic data published over the past month has transformed the narrative.
And even though the BoE tried to address concerns it had fallen behind the curve by increasing interest rates by 50bps in June, the likelihood is that it will still need to do a fair bit more.
The reason for the turnaround is high inflation. Like many economists, the BoE expected inflation to steadily fall back as the impact of the fall in wholesale gas prices fed through.
The inflationary pressures from energy do seem to be abating – Ofgem’s price cap will fall sharply from this month, while the scale of price rises from energy-intensive sectors has fallen. But this source of inflation has been replaced by another – firms passing on the impact of strong wage growth.
The BoE has long identified this scenario as a potential risk but hoped that the substantial increase in interest rates over the past year would head off the threat. However, data published over the past few weeks has suggested that the risk has become a reality.
Private sector regular pay – the BoE’s favourite measure of wage growth – accelerated to 7.6% in the three months to April. Though this was partly a function of the near-10% rise in the national minimum wage that month, the pickup was broad-based and sectors which tend not to employ many lower paid staff also reported stronger pay pressures.
Strong pay growth is now feeding into high inflation, particularly in the services sector. Rather than continue to drift down, CPI inflation held steady at 8.7% in May. And services inflation accelerated to 7.4%, the highest rate since 1992 and well above the BoE’s forecast.
Financial markets had repriced aggressively in reaction to the pay and inflation data, pricing in a peak bank rate of around 6% before the June MPC meeting. Effectively markets were saying they had lost faith in the MPC’s previous guidance and had serious concerns about its credibility. The BoE’s response, a 50bps hike and some tough talk that it would do “what is necessary” to bring inflation down, was an attempt to try to bolster its inflation-fighting credibility.
We think the larger hike will help to address concerns that the BoE had fallen behind the curve. But markets appear to have interpreted the BoE’s decision as an implicit endorsement of the recent repricing.
Therefore the pressure on the MPC to go further will not relent and there will be an expectation that the tough rhetoric will continue too. Furthermore, given that the link between high services wage growth and strengthening core inflation has become well established, we expect the MPC to tighten until it has seen clear evidence that those indicators have begun to cool.
We think the MPC will hike by another 50bps in August and 25bps in September, taking bank rate to a peak of 5.75%, nearly 50bps lower than markets are pricing. Rates are likely to then stay at that level until well into 2024.
If the BoE does stop just short of market expectations, it should cap the rise in swap rates and, assuming lenders’ margins hold steady, halt the upward march in mortgage rates. But we think it’s unlikely that mortgage rates will drop back any time soon.
And given we’re in the peak period for fixed rate deals coming to an end, many borrowers face locking in a large increase in their debt servicing costs for at least the next couple of years. Based on mortgage affordability, we estimate that house prices are currently 30% overvalued.
The combination of high inflation and high debt servicing costs will prolong the squeeze on hard-pressed consumers. With the benefit of hindsight, we may well conclude that the BoE is overtightening policy. But its need to regain control of the situation means that a recession might be the price that has to be paid to bring inflation back to heel.
Andrew Goodwin is chief UK economist at Oxford Economics
