The message to the UK’s crisis-weary households from the Bank of England is: brace yourself for Trumpflation – and the higher interest rates it may yet take to rein it in.
Reading the Bank’s quarterly monetary policy report, it is not difficult to understand the fury Rachel Reeves expressed while in Washington this month at the “folly” of the US president’s war on Iran – its economic consequences will hit the UK hard.
As a result of the conflict and the resulting rise in oil and gas prices, the Bank reckons average mortgage repayments are to rise by £80 a month; food price inflation could hit 4.6% by the autumn; and utility bills will jump in July and remain high into the winter.
Overall inflation is now expected to peak above 3.5% by the end of this year: more than a percentage point higher than the Bank’s pre-war forecasts. In its worst-case “scenario C”, in which oil prices hit $130 a barrel and remain there for a prolonged period – alarmingly plausible given Donald Trump’s latest erratic pronouncements – inflation peaks above 6%.
In this higher oil price world, interest rates may have to be raised by more than 1.5 percentage points, to at least 5.25%.
Despite this inflation shock, monetary policymakers have opted not to raise rates yet, with the Bank’s hawkish chief economist, Huw Pill, the only dissenter on the nine-member committee. But their reasons are hardly comforting, pointing to the weakness of the UK’s battered economy in the face of this latest crisis.
The rate-setters’ main concern is not the energy price shock, which they cannot alter; but “second-round effects”, under which firms raise prices and workers negotiate pay rises, to offset higher costs, causing inflation to be embedded in the wider economy.
With GDP growth now expected to be a lower-than-expected 0.8% this year, continued weakness in the jobs market is likely to make it tricky if not impossible for employees to win themselves higher salaries – unemployment is expected to peak at 5.5% next year, even under the Bank’s more benign scenarios. At the same time, policymakers believe cautious consumers will prevent retailers pushing up prices aggressively.
As Threadneedle Street’s governor, Andrew Bailey, put it in his personal paragraph of the meeting minutes, “for now, the softer real economy makes it appropriate to maintain Bank rate”.
Another reason for inaction for the moment is that financial markets have already done some of the Bank’s work for it – with borrowing costs already more than half a percentage point higher than before the Middle East conflict began, the equivalent of two rate rises.
In his press conference, Bailey stressed that this market “headroom”, might allow the monetary policy committee (MPC) to hold off from rate rises. He appeared to strike a more dovish tone than the monetary policy report, which pointed to the need for perhaps two increases, even in the Bank’s more benign scenarios, A and B, in which oil prices fall back fairly rapidly.
“I can’t give you a cast iron assurance that therefore there will be no [interest rate] increase in any scenario or any of those scenarios. But what I can say to you is that there is a good deal of space available to accommodate that” Bailey said.
However, other MPC members may fear that this market effect – at least in part a bet on higher rates – could yet reverse, if it is not validated by action from the MPC at some point in the coming months.
Even some of the most dovish MPC members, including the external trade expert Swati Dhingra, expressed a readiness to consider raising rates; though she said there was “a limit to how much output loss should be acceptable” – in other words, how much the MPC should be willing to clobber growth, to wrest inflation back under control.
And that is the bleak truth underlying the Bank’s unenviable task in the months ahead. Policymakers will have to weigh the relative risks of two powerful forces unleashed by the Middle East conflict: higher inflation, and weaker growth – and both will make life for cash-strapped British households feel much harder.
