Developments during the last week have reinforced the market’s view that the policy rate will rise from 5% to at least 6.25%.
This follows data showing a further rise in wage growth and hawkish comments on curbing wage inflation from both the Governor and Chancellor.
Given all this, and the focus on second-round inflation, the Bank, like the US Federal Reserve, may find it difficult to stop hiking until either: the labour market softens, interpreting this as wage inflation will ease; or core inflation is shown to have peaked, as this will be the best guide that underlying inflation pressures have eased. Thus, the policy outlook is data-dependent.
There are four channels through which monetary policy tightening works. All are interlinked: curbing monetary growth and limiting the amount of money in the economy; squeezing the real economy, by curbing demand and pushing unemployment higher; quelling inflation expectations; and through a stronger currency. The latter matters more for curbing imported inflation, the others to address domestic inflation which is where the focus is now.
Inflation peaked at 11.1% last October and reached 8.7% in May. Headline inflation looks set to fall significantly further, including in the remainder of this year. The challenge is underlying inflation. Core consumer price inflation, which excludes food and energy, reached 7.1% in May, the highest since March 1992.
Although of no consolation, similar challenges are evident elsewhere. Take the euro area where preliminary estimates suggest headline inflation will fall from 6.1% in May to 5.5% in June. It peaked at 10.6% last October. Meanwhile, the core rate was 5.4% in June versus 5.3% in May and has remained above 5% since last October.
In the US where the Fed’s preferred measure of inflation, the PCE deflator has seen its annual rate decelerate from 5% in February to 3.8% in May. In contrast, the core measure of the PCE deflator, which excludes food and energy, has hovered between 4.6% and 4.7% in each of these last four months, with the latest reading being 4.6% in May. This week’s release of US consumer price inflation meanwhile has eased some of the market’s inflation fears, showing a core rate of 4.8% and headline inflation easing to 3%, suggesting there may not need to be much further tightening by the Fed.
The UK has shown characteristics of the US inflation problem, with a very tight labour market. Although unlike the US where fiscal policy has been relaxed, it has been tightened here. Thus, policy comparisons between the UK and the US are not always fair. At the same time, we have been hit by the energy shock like the rest of Western Europe, while the US avoided this. Moreover, our regulated approach to energy pricing has kept electricity prices higher for longer.
We have been consistent in our assessment of inflation, anticipating the rise in inflation pressures. Early in 2021, we asked which ‘p’ would inflation be. Would it pass through, persist or be permanent? At that time the Bank said inflation would be transitory, thus passing through quickly.
Then the Monetary Policy Committee voted unanimously to keep rates at 0.1% and continue with quantitative easing, an approach that fed inflation. In contrast, we thought inflation would persist. It has. Similarly, I argued that inflation would likely settle post this crisis around 3% to 4%, as opposed to its 1% to 2% from before. That remains our thinking. Likewise, we still take the view that policy rates will also need to settle at a higher level in coming years than was the case before. But it is also important that the Bank does not hike too much now.
Today’s mixed inflation picture
Currently, there is positive, uncertain, and negative news regarding UK inflation.
The positive is that the two factors that led to the surge in inflation in recent years have now been reversed. These were the supply-chain blockages triggered by the pandemic and the war in Ukraine, and the cheap money policies that had prevailed for some time.
Uncertainty surrounds many aspects, including that monetary policy tightening acts with a long and variable lag and thus takes some time to feed through, and there is much tightening that is still in the pipeline and yet to have a full impact.
The negative news is the second-round inflation effects. Here, attention is focused on wages and margins, with the tight labour market adding to wage pressures, and firms passing on higher costs through higher prices, to cover or maintain margins or perhaps even to increase them. The ability of companies to do this will vary, heavily impacted by competition or even the ability of people to afford the higher prices.
Wages have not been the trigger for the UK’s inflation problem. And while one cannot be complacent, now, it is fair to say that higher public sector pay is not inflationary by itself. Also, we do not have a unionised labour force as we did in the 70s and thus a wage-price spiral is unlikely, and in fact, much of the recent pick-up in wage growth has been a lagged response.
Fiscal action is being talked about
I notice that some are arguing that fiscal policy should be tightened further to prevent monetary policy taking all the adjustments. Although I always applaud it when people recognise the role that fiscal stabilisation policy can play, it is nonsense to argue for further fiscal tightening now.
The nature of the inflation shock is key for helping determine the right response. With the first-round effects, which explained the initial surge and thus the vast bulk of the inflation to date, a valid response could have been a tighter monetary policy alongside a looser fiscal policy, but only if that fiscal stabilisation was focused on boosting the supply side of the economy. However, by the time second-round inflation effects emerge, as now, the policy focus tends to be on keeping overall monetary and fiscal policy tight, to squeeze domestic demand and thus avoid an overheating domestic economy.
The latter is where we are now, although in many areas the economy does not feel like it is overheating. Nonetheless, goods price inflation, while falling, is 9.7% and service inflation is 7.4%, having risen.
Taxes should not be hiked to curb inflation. This is the other side of the recent debate where there were calls for fiscal policy to help mitigate the impact of tighter monetary policy. While that was more understandable than the latest call for tighter fiscal policy, specific help for mortgage holders may not be appropriate either, even though it is the highly leveraged sectors like housing that will bear the brunt of higher rates.
In a research paper on first-time buyers last August I noted, “According to the English Household Survey, mortgagers spend 18% of their household income on mortgage payments. In contrast, as a proportion of household income, rent payments represented 27% of household income for social renters and 31% for private renters.” The challenge is that for those remortgaging onto higher rates, the hit will be considerable, and thus it is right that banks will be encouraged to have forbearance, helping those who have been impacted. But it is also clear that rental rates have risen significantly, too, particularly in London, perhaps as the impact of higher mortgage payments are passed on by some landlords. This too will have a significant impact.
In recent months it has been clear there is a lot of pricing power in the economy. For instance, the annual growth in the value of retail sales excluding fuel in May was 7.7% and this continues to far outstrip the growth in the volume of retail sales excluding fuel which fell by 1.7%.
All this adds to the challenge for policymakers to weigh up the full impact of previous tightening alongside responding, but not overreacting, to the latest economic data.
People are paying higher prices, not because they want to but because they have to or can. But as previous policy tightening feeds through, demand will slow and pricing power will ease. The Bank will likely retain a bias to hike until it sees signs of a softer labour market allowing wage inflation to ease, or until core inflation has turned lower.