22 June 2023

Peaking your interest – how much higher will rates go?


No, this isn’t yet another piece having a pop at the Bank of England, and at Governor Bailey in particular. It is fair to say that public confidence in the central bank is low, after a series of policy mistakes, forecast errors and communication blunders. But the Bank has acknowledged most of these faults and we are where we are. Many people will be more interested today in what happens next.

The decision to hike interest rates by a full half point, to 5%, does not necessarily mean that the peak in UK interest rates is likely to be higher than it would otherwise have been. Indeed, it might even be lower.

This is partly about credibility. By going big in response to the poor CPI data for May, the Monetary Policy Committee (MPC) has at least signalled that it is serious about getting inflation back down again. In turn, this should help to keep a lid on the inflation expectations which feed into the setting of wages and prices.

Indeed, surveys both of consumers and businesses suggest that medium-term expectations of inflation are falling. This increases the chances that the current burst of higher pay settlements will be a one-off.

Less positively, the MPC’s apparent willingness to risk a recession to bring inflation down may lead markets to believe that interest rates will be cut again before too long. Consistent with this, the yields on UK government bonds actually fell on Thursday.

But this has an upside too. It cannot be said often enough that the costs of two-year and five-year mortgages depend on where the markets expect interest rates to be over the life of the fix, and not just on the current rate. So everyone saying that this week’s outsized interest rate hike will pile more misery on mortgage borrowers is not necessarily right – and quite possibly wrong.

Of course, things could get worse if the inflation data do not improve – and soon. The MPC was rattled by the unexpected jump in core inflation (excluding food and energy) to 7.1% in May, from 6.8% in April and a low of 5.8% as recently as January. There was also a sharp pick up in services inflation, from 6.9% to 7.4%.

The MPC has clearly signalled its readiness to raise rates again. It repeated the mantra that ‘the risks around the inflation forecast are skewed significantly to the upside’ and that ‘if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required’.

However, whether interest rates do indeed go up again, and by how much, will still depend on the new data and other developments in the coming months. Stronger evidence that underlying price pressures are fading should mean that the peak in UK interest rates will be much closer to the current level of 5% than the 6% (or more) that many fear.

Above all, there are still many good reasons to expect inflation to fall sharply over the remainder of year, including the rapid deceleration in the growth of money and credit.

The June data should start to see the impact of the cuts in the prices of many staple foods that began in the late May. We have also only started to feel the benefit of lower petrol and diesel prices, while most households will see their domestic energy bills fall in July.

Further up the chain, other ONS data on Wednesday provided some more evidence that pipeline pressures are fading. Producer output prices – which are the prices that businesses charge other businesses – rose by 2.9% in the twelve months to May, a much lower rate of inflation than the 5.2% in April and well below the peak of 19.6% in July 2022.

Producer input prices – mainly raw materials – increased by just 0.5%, compared to the record annual high of 24.4% in June last year.

And for those worrying about the risk of a wage-price spiral, the labour market appears to be at a turning point. Wage growth is still strong, but more people are returning to work and vacancies are falling again, so labour shortages are easing.

In short, it is worrying that monetary policy decisions seem to hinge on just one or two pieces of economic data. But these data should improve significantly over the coming months.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.