01 August 2023
With inflation at 7.9% and wage growth at 6.9%, the economy is clearly far too hot for the Monetary Policy Committee (MPC) to relax. That’s means the question is whether the MPC hikes rates by 25 basis points (bps) or 50 bps at its 3 August meeting. The recent slowdown in inflation, early signs of easing in the labour market and some evidence that the economy is losing what little momentum it has will could tip the balance towards a 25 bps hike after the bumper 50 bps hike in June. That would take interest rates to 5.25%.
However, there is probably a 40% chance of another 50 bps hike. Despite the recent fall, inflation is far from under control and some members of the committee will see value in sending another strong signal to the market. And given the increasingly long lags associated with monetary policy transmission there may be more merit in front loading rate hikes and pausing earlier.
In any case, rates are likely to peak at between 5.5% and 5.75%, that is significantly lower than the 6.5% financial markets were pricing in just a few weeks ago. But once there, it is doubtful interest rates will be cut until the second half of next year at the earliest.
Falling inflation is positive, but not enough for the MPC to relax
The economic data we have had since the last MPC meeting in June has turned out to be largely in line with what the committee expected. Headline inflation was bang in line with what the Bank expected in June after overshooting for a couple of months. And core inflation and services inflation, both more important from the MPCs point of view, eased. We expect inflation to continue to fall sharply this year, reaching the 2% target by the second half of next year.
What’s more, there are now clear signs that the labour market is starting to ease. The labour supply is recovering evidenced by a 141,000 drop in inactivity in May and there was a further drop in vacancies. Indeed, the vacancies-to-unemployment ratio—commonly referenced by the MPC as the best indicator of labour market tightness—declined to 0.77 in May, from 0.83 in April, and a peak of 1.05 in August 2022.
Finally, the economy remains stagnant. GDP fell by 0.1% month-on-month in May and the fall in the flash S&P/CIPS Composite PMI to 50.7 in July, combined with the drop in the GfK measure of consumer confidence to -30, suggests that the economy is losing momentum in the second half of the year.
All this depicts an economy that is starting to buckle under the weight of the surge in interest rates. That is why financial markets anticipation of where interest rates will peak has gone from over 6.5% a few weeks ago to around 5.75% currently. However, despite the recent slowdown, inflation and the labour market are still far too hot for the MPC to be able to declare its job done. That points to at least a few more rate hikes.
Admittedly, a convincing case can be made to raise rates by 50 bps again next week. It would send a strong signal to financial markets that the MPC is not satisfied with the fall in inflation so far and could reverse some of the easing in financial conditions we have seen over the last few weeks. What’s more, the changing structure of the mortgage market means the lag between when interest rate rises happen and their impact on the real economy is considerably longer than it was during the last tightening cycle. Some estimates put this lag at as long as three years. This would suggest front loading interest rate rises to speed up the transmission to the real economy, even if the terminal rate remains the same.
However, we think most members of the committee will feel that the flexibility to respond to incoming data is more important than front loading rate hikes. Our base case is for a 25 bps hike in both August and September and potentially another 25 bps in November.
High for longer?
Once terminal rate has been reached, whether that is 5.5%, 5.75% or even 6%, interest will probably have to stay there for a while. That’s partly because the aging demographic of the UK means around 35% of households now own their house outright, compared to around 25% in the early 1990s, and the proportion of households with a mortgage has dropped from around 40% to below 30%. As a result, a large portion of households are now insulated from interest rate rises, which will blunt their effectiveness at reducing demand. Rates will have to stay higher for longer to encourage this demographic to lock savings away for longer rather than spending them.
In addition, as mentioned above, the changing structure of the UK mortgage market has lengthened the transmission lag. In the early 2000s about 30% of mortgages were fixed, compared to above 90% now. While the interest rate on new mortgages has creeped over 6%, the effective rate, which is the average mortgage rate paid, is still below 3%. This means higher rates will eventually lower demand, it will just take longer – perhaps over two years – for rate hikes to impact the economy.
The effect of the changes in the housing market are clear when we look at household interest payments. The combination of rising interest rates and increasing debt levels pushed households’ net interest payments up from around 5% of nominal disposable income in the early 2000s to almost 10% by early 2008. Over the same time, the amount households gained on their savings rose from about 3% of disposable income to about 7%, so interest rates represented a roughly 3% drain on households’ disposable incomes during the last tightening cycle.
In contrast, this time around households’ income from savings has risen more quickly than interest payments, because most savings accounts are floating rate whereas most mortgages are now fixed rate. The result is that households in aggregate are around £10bn better off because of the increase in interest rates.
Admittedly, this won’t last. As more people re-mortgage, interest payments will increase while income from savings will remain steady. The main problem is that those with a big stock of savings are also unlikely to have significant amounts of debt, such as mortgages. Given there are now almost as many households that have paid off their mortgages as those with mortgages, interest rate rises will make almost as many homeowners better off as worse off. As a result, the total drag of higher rates on aggregate household disposable income will be less than 1% this year.
But it does mean that, in order to reduce aggregate demand, interest rates will have to stay higher for longer. We don’t expect interest rates to be cut until late next year and even then, only gradually.