18 September 2023

The week ahead

Monetary policy and mountain ranges 

What do monetary policy and mountain ranges have in common? Quite a lot, according to the MPC. In a speech in Cape Town, the Bank’s Chief Economist, Huw Pill, said he preferred a path of interest rates that looks a bit like the city’s famous Table Mountain, in that rates don’t rise by much more but stay there for quite a long time. Other members of the MPC, however, are known to prefer a path more akin to the Matterhorn (the mountain depicted on Toblerone packaging), where rates would continue to rise steeply, potentially tipping the economy into recession, and come down quickly if needed. 

To us, the Table Mountain approach looks much more appealing. After all, there is a significant lag between a rise in interest rates and its impact on the economy. We estimate that only about half of the surge in interest rates has so far come through to the real economy, so interest rates at current levels will still have a significant dampening effect on inflation and the economy for a while yet. 

The economic data we have had since the last MPC meeting in August has largely gone the committee’s way. Inflation fell to 6.8% in July, in line with the committee’s latest forecast. What’s more, unemployment rates recently rose to 4.3%, reaching the MPC's estimate of its equilibrium rate four quarters earlier than it expected. And after the 0.5% m/m drop in July, GDP looks like it will rise by just 0.1% q/q in Q3, far below the MPC's 0.4% forecast. So far, so good. 

The problem, however, is that wage growth has far exceeded the MPC’s expectation. Admittedly, the headline rate of pay growth of 8.5% was bumped higher by public sector bonuses. But private sector pay, excluding bonuses, was still 8% – miles ahead of the 3.5% rate the MPC thinks is consistent with its 2% inflation target. 

That suggests the committee will opt for a 25bps hike next week, although the vote will almost certainly be split. However, the easing in the labour market and emerging weakness in the economy means that will likely be the last of the rate hikes. We then expect interest rates to remain at 5.5% until the second half of 2024, by which time inflation should have subsided by enough to allow the MPC to start gradually cutting interest rates. 


CPI inflation: A minor bump on the downward path

The headline rate of CPI will probably have ticked up to 7.1% in August. That would match the forecast the MPC made in last month’s Monetary Policy Report. The rise will be driven by the recent sharp increase in oil prices and changes to alcohol duty filtering through to prices. 

More important for the MPC will be services inflation as this is much more closely related to underlying price pressures in the domestic economy. After all, there is not much the MPC can do about international oil prices and alcohol taxes. The good news is that services inflation probably eased slightly, as some abnormally large increases in airfares and accommodation in July return to normal.

However, given the large overshoot of wages in July, inflation would have to come in significantly below 7% to convince the MPC to go for an early pause at its meeting on Thursday. 


Retail: Low confidence holding back sales

Retail sales might have managed a rebound in August after an unseasonably wet July. However, the rebound in consumer confidence so far this year hasn’t resulted in an improvement in retail sales. Inflation has eaten away at consumers’ real incomes, meaning any improvement in incomes will probably be offset by rising interest rates and a need to rebuild savings. 

Households’ real disposable incomes should start to grow again in the second half of the year, as inflation and energy bills fall sharply. Indeed, a relatively tight labour market will keep wage growth elevated. 

However, 100K households a month are refinancing a mortgage and paying hundreds of pounds a month more. And even households not re-mortgaging this year may be paying down debt ahead of future refinancing. Finally, higher interest rates will encourage those firms with cash to save it, rather than spend. 

As a result, we don’t expect the rebound in households’ real income to translate into a spending boom. 

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