Bank of England: All about inflation

The Bank of England (BoE) Monetary Policy Committee raised rates 50bps today to 5.00% on a 7-2 vote (2 voted to keep rates unchanged).

After strong inflation data earlier this week, a 50bps rate rise shouldn’t have come as that much of a surprise. The Bank aren’t clearly signalling what they are likely to do next, but they have been hiking rates in response to persistent inflation pressures. Their messaging at this meeting remained the same: “If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required”. I continue to expect them to raise rates a little further given the continued strength in domestically driven inflation pressure.

Why did they hike?

In my view, this remains all about inflation. Those who voted to raise rates argued that:

1. Second round effects in domestic prices and wages were likely to take longer to unwind than they did to emerge;
2. “Significant upside news” in recent data that “indicated more persistence in the inflation process” (the minutes highlighted Consumer Price Index (CPI) inflation itself; that services inflation was 0.5% stronger than they expected in their May forecasts; and that regular pay growth was 0.5% stronger than they’d expected in May);
3. Although “some indicators of future pay growth and goods inflation had weakened”, they argued that “their properties as leading indicators had not been tested in a similar period of high inflation”.

The economic backdrop hasn’t been telling the Bank to stop

Although there has rightly been much focus on household experiencing significant financial pain as mortgage rates have risen, so far the economy has proved surprisingly resilient in the face of big cost-of-living shocks and 13 rate hikes. Most strikingly perhaps, the economy continues to generate jobs and by UK standards the unemployment rate remains very low. Meanwhile, inflation is a problem. Whether looking at headline inflation, core inflation, services inflation or wage inflation, it’s all too high when set against the Bank’s 2% inflation target. The Bank has been tasked by government to maintain price stability (defined by hitting a 2% CPI inflation target) and the Bank’s main tool at its disposal to get inflation down is interest rates…

Mortgage rate risks

As households are rolling off expiring two-and five-year fixed rate mortgages, they are clearly facing large jumps in mortgage payments. Are the Bank therefore going too far by continuing to hike? I don’t think that the Bank of England need to hike much further, however:

• First, mortgage rates are a key channel through which rate hikes by the Bank of England feed through into the economy, helping to slow inflation. Higher mortgage rates eat into household finances and thereby help cool spending and economic activity more broadly. For an economy to slow, for inflation to cool, pain will likely need to be felt by some.
• Second, policy rate changes don’t feed through one-to-one into new fixed term mortgage rates. Market expectations for how much tightening the Bank still needs to do, matter. Just because the Bank hikes a lot in the near term doesn’t necessarily mean an average 5-year fixed mortgage rate will end up rising.
• Third, because fixed rate mortgages, and particularly those with longer than two-year terms, have become more popular in recent years, Bank of England rate rises are likely feeding through to the economy with longer lags than usual. However, rate increases may also now be less effective in slowing the economy: A lower proportion of households now own their house with a mortgage. Further, some households were able to build substantial stocks of savings over the pandemic and these have ‘shielded’ some households. So, to have the same effect on the economy, the Bank may have needed to have raised rates more than they would have done say a decade ago.

Could we get government help for those with mortgages?

There is significant political pressure for the government to help those facing higher mortgage rates. However, since this is one of the main channels through which monetary policy operates, blanket support seems counter-productive to what the Bank of England is trying to do. There is a clearer case though for the government to help some of the most vulnerable households. There are schemes that could be expanded/revived – for example from the financial crisis era – largely taking the form of loans or guarantees with limited implications for the fiscal deficit, and particularly targeted at vulnerable households with mortgages who found themselves in arrears, for example because of job loss.

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