Bank of England officials are expected to take their foot off the accelerator when they meet this week to decide how much to increase borrowing costs.
The prospect of a year-long recession that will hurt living standards, cut business investment and hurt the UK economy’s long-term productive capacity may have made them think twice about an increase, but financial markets are betting that a 0.5 percentage point rise on Thursday seems safe.
At the central bank’s Monetary Policy Committee (MPC) meeting last month, interest rates were raised by 0.75 percentage point to 3%, so this week’s hike is likely to be seen as a more modest turn of the knife for mortgage holders.
A year and a half ago, borrowers could find a two-year fixed-rate mortgage with an interest rate of 1.5%, now they have to accept 5.5% and be happy that it won’t go much higher.
Paul Dales, UK chief economist at consultancy Capital Economics, says that when the MPC meets, it “may indicate that it is starting to think more about the level of interest rates than the pace of rate hikes”.
“Nonetheless, we think it wants to see more concrete signs that domestic inflationary pressures are easing before halting rate hikes,” he adds.
The consumer price index (CPI) came in at 11.1% in October, the highest inflation the UK has faced in 41 years, and since May last year inflation has been above the bank’s 2% target. Most analysts believe we’ve hit a peak and this week’s numbers will show that the CPI for November fell slightly, although the rate of increase is likely to remain close to double digits at least into spring.
However, prices could fall sharply if service firms facing a drop in demand find the only way to sustain sales is by lowering prices. Business services and financial firms have reported record profits over the past year and could well afford to squeeze their margins.
The OBR recently said inflation-adjusted wages would not return to 2008 levels until 2027
The MPC is split between a majority who believe consumer spending has refused to bend to the bank’s will and that shoppers need a few more rate hikes before the pain starts to bite, and a minority who believe Bearing the weight of additional borrowing costs already has the desired effect.
In the US, inflation began to fall in response to price cuts by service companies. The same could happen in the UK and Europe.
Joe Nellis, professor of global economics at Cranfield School of Management, says that while consumer spending in the UK has held up – thanks to low and falling unemployment, the accumulation of savings during the pandemic and a growing reliance on credit – this situation is fast changing could reverse in the new year as wage increases continue to lag inflation. “We’re going to see a sustained decline in living standards over the next two years, the likes of which we haven’t seen in 100 years,” he says. “We are in a precarious position”
The Office for Budget Responsibility, the Treasury Department’s independent forecaster, emphasized this point when it recently said inflation-adjusted wages would not return to 2008 levels until 2027.
John Llewellyn, a former senior economist at the Organization for Economic Co-operation and Development, says the UK is in a worse position than the US, where the Biden government is spending heavily to avoid a recession. The rest of Europe, facing acute domestic and industrial gas shortages, is on a slight downward trajectory.
“Although Europe has to be gloomy, having been hit hard by deteriorating terms of trade and higher energy prices…there’s only one place where a deep recession is guaranteed and that’s the UK,” he says.
In its most recent assessment, the Bank of England said a recession would be long but shallow.
Dales says interest rates could stay above 4% for all of next year before falling in 2024 as the bank focuses on flushing inflation out of the system. However, many other economists believe rate cuts could come as early as the spring to keep a recession from turning into a slump.
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