Britain will be the last advanced economy locked in a pitched battle against inflation, if market bets are any guide.
(Bloomberg) — Britain will be the last advanced economy locked in a pitched battle against inflation, if market bets are any guide.
Money markets suggest the US Federal Reserve has done all it needs to stabilize prices after Wednesday’s quarter point interest rate hike 5.25%. They anticipate the European Central Bank, a late starter, will raise rates twice more – stopping at 3.75% after Thursday’s quarter point increase to 3.25%.
But the Bank of England, the first to tighten back in December 2021, is expected to increase rates a quarter point to 4.5 next week and then again by August, with a more than 1-in-4 chance of a final hike to 5% in September. It has tightened more than the ECB and has been hiking longer than the Fed, but still has the most left to do.
“Inflation is proving more of a problem in the UK,” said Martin Weale, a former member of the BOE’s monetary policy committee and now professor at King’s College London. “It does look more entrenched here. That does mean monetary policy needs to be tighter in the UK.”
Britain’s unfortunate exceptionalism has been well documented. The UK has endured a combination of both the acute labor shortages experienced by the US and Europe’s energy price shock. The difference now is that the tight US labor market is easing, and European energy prices are falling. Yet Britain’s problem remains.
A quick glance at the data suggests the UK is now in a uniquely perilous position. Headline consumer price inflation is in double digits, at 10.1%, which is five times its mandate. It’s well above the 6.9% headline rate in the eurozone and 5% in the US.
The comparison is slightly misleading because of a price-capping mechanism on consumer bills that’s delaying the slump in natural gas prices from hitting the bottom line. The next reset will automatically reduce headline inflation by 2 percentage points, Bloomberg Economics estimates. Another percentage point will automatically drop off in July.
However, underlying measures that give a clearer signal about longer term price pressures are also elevated in Britain. Core inflation is 6.2% in Britain and 5.6% in the eurozone. The Fed’s preferred measure, core personal consumption expenditure, is 4.6%. Above all, there is the problem in Britain is wage growth.
Regular weekly earnings are rising at 6.6% a year in the UK, compared with 4.2% for average hourly earnings in the US. So as long as interest rates are lower than pay rises, monetary policy is not tight enough, said Stephen King, HSBC senior economic adviser and author of “We Need To Talk About Inflation.”
“That would suggest the UK has an inflation problem that is in danger of becoming more embedded than the US,” he said. “Monetary conditions in the UK are too loose.”
Britain is still in the grip of a labor market crisis. Unlike every other G-7 economy, the UK has fewer workers now than before the pandemic — almost one job vacancy for every unemployed person. Two thirds of employers say hiring is more difficult than normal, according a BOE survey of company executives.
That labor market tightness, combined with the terms of trade shock from higher gas prices, has sparked a conflict between workers and employers over inflation. Workers are trying to recover their living standards by demanding higher wages, through strikes in some cases, while companies try to repair their margins by raising prices.
BOE Chief Economist Huw Pill described the dynamic of the two groups competing for the nation’s reduced resources as “pass the parcel,” driving inflation ever higher. “Someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether higher wages or passing the energy costs through onto customers,” he said, in comments that sparked widespread anger on April 25.
King at HSBC said history shows that there’s only one way to end an inflation-chasing conflict — kill economic demand by raising rates.
“This conflict process is only sustained when monetary policy is not tight enough,” he said. “It’s often the case that to get rid of inflation, unemployment has to go up and the economy slows or goes into recession.”
For the moment, the UK economy appears to be more resilient than expected. Last November, the BOE forecast the longest recession in a century. In February, it revised that to a short slump.
Next week, it will unveil its latest economic forecasts when “we expect the Bank to remove much, if not all, of the recession that it had been expecting previously,” said Nomura chief European economist George Buckley. A stronger economy would imply more persistent inflation, however, and therefore more rate rises.
The BOE’s nine Monetary Policy Committee members are divided on whether more tightening is necessary. Two believe the lag between policy and its economic impact, which can take two years, means the pain is yet to be seen.
Silvana Tenreyro, who has resisted rate hikes more than any other MPC member, last month compared further increase to Milton Friedman’s “fool in the shower.”
“When the fool starts the water and it runs cold, he keeps turning the faucet and, eventually, because he’s impatient, he gets burned,” she said, arguing that rates are already too high for the economy to withstand.
For the 4 million UK homeowners who the BOE says face an increase in their mortgage rates this year, financial difficulties lie ahead. Two of the MPC members are expected to vote to hold rates, or even call for a rate cut, in anticipation of that trouble.
Fed Chairman Jerome Powell said on Wednesday that he too was worried about those lags. “It will take time, for the full effects of monetary restraint to be realized,” he said.
Read more:
- BOE Official Says UK Rates Are Already Too High for Economy
- UK Economy Shows Resilience in Stronger Mortgage and PMI Data
- UK’s Stronger Economic Data Lock In Case for Further Rate Hike
–With assistance from Andrew Atkinson.
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