Economics & StrategyEmail
Simon French, Chief Economist
Published: The Times 30/10/2021
The recent increase in consumer prices around the world has largely been described as “temporary” or “transitory” by Central Banks. Despite vocal criticism in some circles, these have been helpful terms. The language has helped reassure investors, businesses and households that the most egregious examples of inflation are the function of a once-in-a-century disruptive event. They have been a corrective to fears that we are at the dawn of a new, high inflation era. This language from monetary policymakers has also helped calm market fears that interest rates on mortgages and loans, as well as on corporate and government debt, are going to move dramatically higher. As an enabler of a rapid economic recovery this has been a job well done by the world’s Central Bankers. The global economy is now back to its pre-COVID level of activity less than two years from the onset of the pandemic-induced recession. Unemployment has been the dog that has not barked. That is an extraordinary achievement. It sits in sharp contrast to the Global Financial Crisis when a series of policy missteps hampered the recovery. However, with this rapid rebound we are now entering a period where the language on inflation and interest rates must subtly, but decisively, change.
On Thursday the Bank’s Monetary Policy Committee (MPC) will announce their latest interest rate decision. Financial markets see it as a coin toss whether the Committee will raise interest rates for the first time since August 2018. At the very least they will have to explain how UK inflation – now well above its 2% target – is expected to evolve from here. Recent speeches by some of the Committees’ nine members have generated a kaleidoscope of views on the strength of the recovery and their appetite to take away the monetary policy punch bowl. The MPC are not alone in their diversity of opinion. I cannot remember as feverish a debate on inflation at any point in the last two decades. Even technology entrepreneurs such as Twitter founder and cryptoasset advocate, Jack Dorsey, have been wading into the debate in warning of hyperinflation in the United States economy. Mr Dorsey’s intervention may not be entirely objective given his crypto interests, but he carries considerable influence on public opinion. Central bankers remain acutely sensitive to the public’s expectations. Earlier this month Bank of England Governor, Andrew Bailey, noted medium-term inflation expectations as key pieces of information for considering a UK interest rate increase.
Stepping back, it must be recalled that at their current rate of 0.1%, any upcoming interest rate move will still leave the UK policy rate materially below the 0.75% level it was in early 2020. There will also be ongoing purchases of government debt by the Bank of England for some considerable time to come – an exercise designed to keep market interest rates at modest levels. Whilst lenders have been withdrawing their most attractive lending rates, data released by the Bank of England yesterday suggested that the average interest rate on new mortgages in September was just 1.78%. New unsecured loans had an average interest rate of 6.02%. Both these interest rates are also lower than they were at the onset of the pandemic. A modest uptick in these interest rates over the coming months will also be cushioned by the boost it will give to the income of savers. Britons are now sitting on almost £1.2trillion of easy access savings – a figure that has grown by almost 25% since the start of 2020. Higher interest rates are not a one-way street for household spending power.
The bigger question the Bank of England will have to address next week is not the impact of any immediate interest rate increase, but whether financial markets are right to assume at least four more will follow over the next twelve months. Whilst I think most balanced observers would argue that the UK economy can absorb a gradual return to pre-COVID interest rates, faster and larger moves are more likely to translate into consumer caution and have a chilling effect on investment. It is one of the reasons why I believe that financial markets have got carried away with the scale of the tightening likely from the Bank of England. They will proceed cautiously, looking for feedback at every stage.
To do this, the Bank of England’s communications will need to build out from simply describing inflation as transitory and temporary – to acknowledge the lived experience of inflation for many Britons. If prices have moved higher because of the reopening economy and will plateau off at a higher level this will feel like a cost-of-living squeeze for many households. This will persist even as inflation – a rate of change measure – likely comes down during the second half of 2022.
Nuanced communications will need to explain that all over the world both workers and goods have found themselves in the wrong part of the economy for where consumers want to spend their money. Restrictions on purchasing foreign holidays and leisure activities have meant a surge in demand for goods and construction materials. This has exposed capacity constraints on shipping and haulage where spare capacity was already in short supply. All these factors should ease as the vaccine programme rolls out further and confidence in health outcomes improve. With this progress the upward surge in consumer prices should begin to moderate.
There is however a very practical message coming from this period. Households and businesses should focus on ensuring that any borrowing is manageable if interest rates move higher. Regulated lenders are asked to ensure that mortgage borrowers can afford a full three percentage point increase in their mortgage rate. Given the flux in many borrowers’ incomes during the pandemic that rule of thumb remains a good starting point for resilience to what may lie ahead. Financial markets are certainly not expecting rate increases on anything like that scale, despite recent volatility.
No economist, however confident they sound, knows precisely what lies around the corner. Having seen debt interest payments fall steadily for thirty years, at the very least this looks set to level out for borrowers over the coming few years. In order to retain public trust policymakers need to communicate a clear and confident story. For the Bank of England this exercise will start in earnest next week.