Winning the UK’s inflation battle will require more than just interest rate hikes

The UK is grappling with one of the most stubborn inflationary challenges worldwide, exacerbated by labour market dynamics and declining real wages which will require structural reforms to bolster Britain’s productive potential and reverse the weak growth outlook.

UK annual CPI was 8.7% in the year to May 2023, more than fourfold higher than the Bank of England’s (BoE) 2% target. Bank of England Governor Andrew Bailey said the UK inflation rate will drop “markedly” in the second half of this year, but warned the full impact of existing interest rate increases has yet to hit the economy. Chancellor Jeremy Hunt admitted that the UK’s historically tight labour market was “pushing up inflation even further”. Job vacancies are still above one million despite a decline of 85,000 in the three months to June, according to the latest Office for National Statistics (ONS) data. Markets anticipate the BoE will raise interest rates by a further 150 basis points to dampen inflation, implying a peak base rate of 6.5%, which compares to 4% by the European Central Bank and 5.5% by the Federal Reserve.

However, while the use of interest rate increases as the premier tool to dampen inflation is ubiquitous in central banking, it is a blunt tool at best. Rate increases do not directly address the root causes of the UK’s inflation problem, which is driven by structural factors (e.g. a declining UK labour force due to a post-pandemic spike in long-term sickness and early retirement) and external shocks (e.g. historically high energy and commodity prices caused by the Ukraine war, as well as supply chain pressures post-Covid and trade frictions post-Brexit). It is self-evident that a higher base rate, which principally increases mortgage and credit card payments for British consumers, does not alter that equation. Furthermore, both external and structural forces are exacerbated by lagged effects, as the transmission of monetary policy to the broader economy takes time, as noted by BoE’s Andrew Bailey.

Labour market dynamics

While much of the supply-side disturbances have eased, the UK’s labour market remains problematic for the BoE’s inflation fight. Newly published ONS data reveals a record annual wage growth rate in the UK. Wages increased by 7.3% in the three months to May, surpassing expectations. Wages rose fastest in the finance and business services sector at 9%, and the manufacturing sector at 7.8%. However, real wages are not keeping pace with the UK’s annual rate of inflation. Declining real wages – which fell by 1.2% over the three months to May – is problematic and adds to the challenges faced by Monetary Policy Committee (MPC) members in their efforts to tame stubbornly high prices without the risk of tipping the UK economy into a recession.

Rate increases relationship with economic growth

The impact of interest rate increases on UK economic growth is worth evaluating. Eventually, higher interest rates dampen economic activity, creating a delicate trade-off between inflation and GDP. As borrowing becomes more expensive, businesses reduce their spending on expansion and hiring leading to slower economic activity. Lagged effects can delay awareness of this relationship. Monthly real gross domestic product (GDP) is estimated to have fallen by 0.1% in May 2023 after growth of 0.2% in April 2023, as shown in the latest ONS data. Capital Economics noted that in construction and real estate – two of the most sensitive sectors to higher interest rates – output for both fell 0.2% month-on-month in the third and second consecutive declines respectively.

“Our sense is that underlying activity is still growing, albeit at a snail’s pace,” wrote Paul Dales, Chief UK Economist at Capital Economics. “The further surge in mortgage rates since mid-June will contribute to GDP falling in Q3 and a mild recession beginning. That may not prevent the Bank from raising interest rates from 5% now to 5.25% or 5.5%, but it may mean rates don’t rise as far as the 6–6.25% priced into the market.”

The BoE and the International Monetary Fund (IMF) are more optimistic and both expect the UK to avoid a recession this year; however, the IMF warns the UK needs structural reforms to reverse the weak growth outlook and realise Britain’s productive potential. Chancellor Jeremy Hunt’s raft of policy announcements in last week’s Mansion House speech is best seen in this context. Hunt aims to encourage the redirection of pension fund capital into high-growth unlisted equities, including but exclusively UK companies, to stimulate economic growth, while yielding higher returns for pension savers and capitalising on the regulatory freedoms provided by Brexit.

Trans-Atlantic comparisons

As higher interest rates increase the cost of mortgages, homeownership and refinancing become more difficult for individuals to afford. In the UK, shorter-term mortgage deals are prevalent, which creates a relatively sudden cliff-edge in rising interest rates increasing the financial strain on homeowners, impacting consumer spending and overall economic stability. By contrast, in the US, banks are able to provide 30-year fixed-rate mortgages, which insulates domestic homeowners from the impact of rising interest rates, negating a significant negative consequence of the rapid tightening in monetary policy on the real economy. This trans¬atlantic difference in mortgage markets is a significant driver of the differing UK and US inflation experience in this cycle.

In summary, the UK’s battle against inflation is more complex than the experience of most advanced economies and interest rate hikes alone are not a panacea. Structural changes to revitalise labour market dynamics, smooth supply chain disruptions and trade frictions, as well as offset the impact of Britain’s short-dated mortgage market, may well support a more sustainable victory over inflation. The battle is far from won.