The BoE unexpectedly left the Bank Rate unchanged at last week’s meeting. The decision followed a surprise drop in headline inflation, which coupled with weaker than expected growth suggested that policy settings are now sufficiently restrictive to bring inflation down lastingly. Markets have trimmed expectations for peak rates in the UK substantially, and we see a good chance that the BoE will not hike again. The central bank is fighting waning confidence in its policy decisions and will likely err on the side of caution as growth slows, though rising oil prices could still throw a spanner in the works.
UK headline and core inflation unexpectedly declined in August. At 5.7% for the headline and 6.2% for the core, the key measures corrected -1.1 percentage points and -0.7 percentage points respectively. This was partly due to special factors, as base effects from holiday-related prices played a role, and those can be impacted by the timing of school holidays. Prices paid at restaurants and hotels dropped -0.1% m/m in August this year, compared to a 1.0% m/m rise in August 2022. This helped the general services price indicator to slow in the annual comparison.
Special factors aside, there are some indications that waning demand is helping to keep a lid on price pressures now. Wage growth may have remained surprisingly strong in recent months, but with food price inflation still running at over 13% y/y and debt financing costs much higher than a year ago, consumers are still struggling with a limited budget.
Annual house price growth has decelerated to just 0.6% y/y, according to ONS numbers, as rising debt financing costs deter buyers. Halifax data showed that the number of first-time buyers in the UK has fallen by more than a fifth, with 22% fewer first time-buyers through the first eight months of 2023 than in the corresponding period last year. They still accounted for more than half of all home loans agreed to over that period, but the drop flags that renting is becoming increasingly important for the younger generation. And in line with debt financing costs and the rise in demand, the ONS reported that private rental prices rose 5.5% y/y in August. This was the largest annual percentage change since the start of the series in 2016.
The BoE’s pause has seen mortgage rates nudging down again, but for around 4.5 million households monthly payments have already soared and the consumer group said that 7 million UK households are struggling with rent or mortgage payments. For an additional 2.1 million the shock of higher rates is still to come as just under a third of homeowners will see their fixed rate deals finish by the end of next year. And with house prices coming down in some measures the number of those stuck in negative equity is also picking up.
In this environment wage demands are playing catch up with the rise in the cost of living, though whether a higher paycheck really increases spending power crucially hinges on whether companies absorb the uptick in costs, or whether they pass on the rise in pay. ONS analysis shows that so far wage growth explains most of the price increases across the services sector. The pass through was particularly strong in law, accounting and management consultancy, while in contrast, in manufacturing, “price growth was caused by other factors”, such as a surge in import prices amid supply constraints and higher oil prices.
The latest PMI report flagged that budget constraints are now encouraging restructuring efforts over replacement of voluntary leavers. This prompted an abrupt turnaround in private sector employment numbers with the survey suggesting that “aside from the pandemic lockdown months, the rate of job shedding was the fastest since October 2009“. The labour market then is looking less tight than it was, and while companies still flagged strong wage pressures, they also reported that this was “counterbalanced by the pass through of falling commodity prices by suppliers of raw materials”.
Despite the fact that the survey pointed to “the slowest rise in private sector business expenses since January 2021“, S&P Global/CIPS also reported that “prices charged by private sector companies increased at a robust pace”, with companies passing on higher operating costs, especially salary payments. However, the “overall rate of prices charged inflation decelerated to the weakest for over two-and-a-half years”, with a number of respondents flagging “greater competition for new work and the moderating impact of falling demand”.
So there are some signs that market conditions are changing, also thanks to the BoE’s extended series of rate hikes. GDP already contracted -0.5% m/m at the start of the third quarter, and while the PMI report flagged surprisingly strong optimism about the outlook for companies over the next 12 months, the risk is that those hopes will be disappointed. Consumer confidence has also picked up lately, which may reflect the improvement in real incomes. However, excess savings built up during the pandemic have largely evaporated, and with oil prices rising again, there still is the risk of fresh setbacks for both households and businesses.
With less room to pass on higher costs, a renewed rise in input costs would undermine company profits. And after the BoE’s dovish turn, Sterling has been on a downtrend, which will exacerbate the impact of higher energy prices. This flags the difficult situation for the BoE, which is already facing a crisis of confidence. The latest BoE/IPSOS survey showed that 40% of respondents think the bank is doing a bad job of handling inflation, up from 34% in May. The net dissatisfaction reading of -21% marks a further deterioration versus the -13% in May, and is the worst since the start of the survey in 1999.
Many have argued that the BoE started to hike rates too late, also thanks to inaccurate inflation forecasts. In this narrative, keeping rates too low for too long is partly to blame for the ongoing inflation overshoot. The central bank itself has admitted that its inflation projections were flawed and started an investigation into ways to improve forecasting models. In the current situation a lack of trust in the BoE’s projections is only adding to concerns that the BoE will get it wrong again and go too far the other way, risking a recession in the process.
High mortgage rates are now a key part of the narrative surrounding the cost-of-living crisis, and PM Sunak is eager to be seen as addressing the problem as he prepares for the upcoming election campaign. Polls give the Labour Party an 18 point lead over Sunak’s Conservative Party, and additional rate hikes could be equally damaging as high inflation rates as the government attempts to present a shift to consumer-oriented policies.
The BoE may be independent, but with rates already at restrictive levels now, the hurdle to additional tightening is higher in this environment. The next meeting on November 2 will come with the new Monetary Policy Report and updated projections and there is a good chance that the BoE will maintain a cautious wait-and-see stance. Oil price developments remain in focus until then as a renewed surge in energy costs could still throw a spanner in the works.
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Andria Pichidi
Market Analyst
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