Bank of England winning against inflation…

Source: Tatton Investment Management, "Tatton Weekly" 13/09/2023

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Bank of England winning against inflation expectations

Britain’s inflation outlook is back in the spotlight (if it ever left) this week. The International Monetary Fund (IMF) published a gloomy report in which it forecasts high UK inflation into next year. It thinks prices will jump 7.7% year-on-year in 2023, and 3.7% in 2024. This is the highest predicted inflation rate of any G7 country, and it could mean another interest rate rise from the Bank of England (BoE), with UK rates staying well above peers to the end of this decade. This is despite the IMF downgrading Britain’s growth forecast to just 0.6% in 2024 – the lowest of any developed nation.

The UK government tried to paint the IMF’s predictions as overly pessimistic, with the Treasury arguing recent growth revisions had not been accounted for in its report. Reacting to the forecast on Tuesday, Chancellor Jeremy Hunt pointed to a higher long-term growth rate in the UK than in Europe’s largest economies and reiterated his stance that “we need to deal with inflation and do more to unlock growth”. The IMF naturally rejected these suggestions, arguing that its growth forecasts were above the BoE’s and factored in all available information.

In truth, there are some reasons to doubt the IMF’s outlook. We can all agree that UK inflation has proven particularly persistent – compared to both other countries and our own history – but there has been a noticeable easing of price pressures in recent months. Headline consumer price index (CPI) inflation has been trending downwards since February, with the latest print of 6.7% in August. This is likely to come down further when September’s figures are released, thanks to the food price spike tailing off and increased supermarket competition.

Of course, like all central banks, the BoE focuses much more on ‘core’ inflation – excluding more volatile elements like food and energy. Core CPI has been less encouraging this year, spiking through the spring after what initially looked like a cooldown. Core CPI inflation peaked at 7.1% year-on-year in May, but there has only been a very mild retreat since then. June and July both saw prints of 6.9%, while in August core inflation was still up at 6.2%.



The chart above illustrates nevertheless how fast and how far inflation rates have come down in the UK , even if this particular way of presenting the data somewhat overemphasises the most recent data points.

The problem with all these figures is that they are inherently backward looking. The BoE sets interest rates based on the expected prices into the future – but inflation rates, even core ones, very rarely simply carry forward. Central bankers are interested in backwards indicators like core inflation only to the extent they feed into future inflation pressures, primarily in the form of wage rise pressures. As the BoE has repeatedly emphasised, policymakers are worried about the tightness of the UK labour market and continuation of a wage-price spiral – one of the factors that pushed core inflation up again this year.

Average earnings increases have been high for some time (on a year-on-year basis at least). But lately these have cooled off somewhat. More importantly for future wage levels, employment levels have shown definite signs of slowing down. The chart below shows survey data on job placements and availability of employees – along with forward predictions by from the UK’s



Recruitment and Employment Confederation (REC) for the next six months.

This is essentially a measure of employment expectations, where the horizontal line represents a labour market in balance – the relative number of workers and available jobs is such that neither group has excessive pricing power. As you can see, employment levels have moved much closer to balance through the year. Things remain tight – and indeed, there has been a small spike in recent months – but analysts expect the labour market to loosen significantly in the next few months, moving even below balance.

Researchers at Pantheon Macro suggest these figures are consistent with a 0.5 percentage point increase in the unemployment rate year-on-year. This should lead to month-on-month wage increase figures slowing into the end of this year. And given that keeping a lid on wages is the BoE’s proclaimed goal in its inflation fight, this should mean the BoE has delivered its last rate rise of this cycle. Indeed – contrary to the IMF’s warnings – some analysts think it could cut rates substantially by the end of 2024.

Implied market expectations also do not match up with the IMF’s interest rate predictions. In line with the latest inflation and labour market data, bond markets are firmly pointing to the BoE keeping its benchmark rate static at November’s meeting. That would mean two consecutive months of rates on hold and, if inflation comes down again in the meantime, as widely expected, it will send a strong message that the rate-hiking cycle is over.

This would also bring some relief to mortgage rates, which have already come down somewhat from a peak of nearly 6% on average in June and July. Strangely enough, higher mortgage rates have increased inflation pressures – on certain parts of the country at least – through their effect on the housing supply mix. In particular, higher mortgage repayments have forced some landlords to sell rental properties, thereby decreasing the rental supply. In that respect, mortgage relief is likely to ease some of the pressure on rents, meaning that interest rate stabilisation could well help the steady downward path of inflation.

The main hiccup in this story is global supply problems, which have unfortunately become a recurring theme in the post-pandemic world. The gas ‘leak’ in Finland and Estonia – and its impact on energy prices – is a prime example. Thankfully for Britons, the outbreak of further violence in the Middle East has not yet had any discernible impact on oil or energy prices – but it is much too early to tell whether that will continue to be the case. For now at least, the BoE and its global peers can take comfort in how their policies have brought down inflation expectations. It has taken a long time, but central banks seem to have won out.

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