After raising interest rates by a quarter each time, financial markets are betting that Threadneedle Street’s monetary policy committee (MPC) will announce a 0.5 percentage point jump this time, something that has never happened since the Bank received independence 1997. The last time interest rates rose by such a margin, John Major was prime minister, Ken Clarke was chancellor and Eddie George was governor of the Bank of England. This was in 1995, when the Treasury still had the final say on interest rates. If the Bank breaks new ground after independence, it won’t just be because the annual inflation rate is at a 40-year high of 9.4% and is expected to rise further in the coming months. Nor will it simply be a matter of playing catch-up after repeated underestimations of price pressures, although that is a factor. This time last year, the MPC forecast that inflation would peak in late 2021 at just 4%. Rather, the jump will be because the Bank’s fear of inflation being embedded in the economy outweighs concerns that the economy is about to enter a recession or, indeed, may already be in recession. David Blanchflower, a former member of the MPC, said he believed the UK was in the early stages of a recession that started a few months ago. Chart showing interest rates from January 2021 What makes the committee’s work difficult is that the economy is sending mixed messages, as it often does at a critical juncture. Unemployment is back to low levels last seen in the 1970s and there are record job vacancies. Some companies – such as supermarket chain Aldi – have increased wages for their workers twice in the past year in a bid to retain staff. Others, including housebuilder Taylor Wimpey, bank HSBC and energy firm Shell, have announced lump sum payments to help staff cope with the cost of living crisis. The tightness of the labor market worries the Bank as it conjures memories from the 1970s, when prices and wages chased each other higher until inflation peaked at 25% after the second world war. Professor Stephen Millard, of the National Institute for Economic Research, argues that interest rates need to rise from 1.25% to around 3% if inflation is to get back on track, but believes talk of a decade-long wage-price spiral of 1970 is excessive. Chart showing inflation as of January 2021 Median pay settlements averaged 4% in the quarter to June and even with bonuses and lump sums on top, Millard expects only 6% earnings growth this year – well below the rate of inflation. Wage growth is high by recent standards, he says, but not high enough to create an inflationary spiral. The Bank’s decision will also be influenced by what it thinks is happening to underlying inflation, as measured by consumer prices excluding fuel, food, tobacco and alcohol. Here, the trend was encouraging, with core inflation easing for two consecutive months from 6.2% in April to 5.8% in June. More worrying will be the steady rise in services inflation, from 0.7% in June 2021 to 5.2% in June. This would be seen as an indication of price pressures being generated in the domestic economy, rather than being imported from abroad. Chris Williamson, chief business economist at ratings firm S&P Global Market Intelligence, says surveys of manufacturing and service firms show the economy is headed for a recession, and the debate is about how big and deep it will be. He says the Bank must be aware that a 0.5% rate hike and a signal that the key rate is headed for 3% will push the economy into an even deeper recession. Williamson worries that many of the indicators pointing to the economy doing well could quickly reverse if interest rates rise quickly. He warns that this “bullwhip effect” could mean business closures, which have remained low during the pandemic, become widespread, while unemployment, which fell steadily last year to a 48-year low, begins to increase. Subscribe to the Business Today daily email or follow Guardian Business on Twitter @BusinessDesk The housing market, which has proven resilient since the start of the pandemic, could also begin to weaken and prices could begin to fall, pushing some households into negative equity. Tim Bannister of online property portal Rightmove says first-time buyers are facing average monthly mortgage payments 20% higher than at the start of the year due to rising interest rates and asking prices. Meanwhile, existing homeowners, many of whom are nearing the end of a fixed-rate mortgage, must pay higher monthly bills. “With each jump in interest rates, homeowners contribute about 1% more of their gross salary on average to a mortgage, and a 0.5% increase in the prime rate would push average monthly mortgage payments to 40% of their salary” , says. . Another sign of an impending recession can be found in the warehouses of retailers, manufacturers and construction companies. For much of the past year, businesses have stockpiled raw materials and goods in short supply to guarantee they can fulfill contracts and supply customers. However, data from the US shows that the collapse in consumer demand has left companies with mountains of unsold clothing, homewares and furniture. Inventories were high to support sales a few months ago. Now the warehouses are clogged with things that need to be unloaded at a discount, with few potential buyers. Williamson says the problems faced by Walmart and Costco in the US will also apply to large retailers in the UK and across Europe. Krishna Guha, of investment banking consultancy Evercore, expects the Bank to “join the global trend of outsized rate hikes” with a half-point increase to 1.75%, albeit with some reluctance due to the sharp economic slowdown. Like most other analysts, Guha will be looking for clues as to where – with the UK on the brink of stagflation – the Bank will go next.
