Macro matters: What does the recent inflation spike mean for interest rates?
Regular readers may have noticed a gap and my absence can be explained by a new role leading Knight Frank’s ESG-related Research so unfortunately this marks my last of these newsletters.
5 minutes to read
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I thought my final economic piece would be on everyone’s favourite topic – inflation. I examine why we shouldn’t read much into February’s jump.
The CPI read of 10.4% in February caught many off-guard. The consensus view was that we’d see a fall from 10.1% in January to single digits for the first time in six months. The response has been fairly muted, not least because of the banking sector grabbing the headlines. There may be more to come on the food inflation side of things, but overall I believe the trend will continue downward and the Bank of England needs to hold their nerve and see what impact the 11 successive hikes have had on the economy before continuing hiking much further.
One number doesn’t make a trend
Looking back over previous periods and you can see the path down is not always smooth. The current CPI data series from the ONS dates to 1989. Whilst this episode of inflation is higher than previous ones, we can draw some potential parallels. The chart below shows that often after peaking it is rare that we see month-on-month declines in a straight line, and similarly one upward posting is unlikely to indicate a derailment of the overall direction.
Why do I believe this?
Base effects will be the biggest contributor to downward pressure. From April onwards we will really see these take hold as one of the primary drivers, energy prices, will see effects wane. The year-on-year price cap rise in April 2022 saw the household energy prices rise by 54%. We have seen some increases since then, to £2,500 in October, but with the extension of the cap the annual jump recedes to 27%. Another driving factor (pardon the pun) is fuel and there we will see disinflation. The average petrol price in April 2021 was c.£1.26, in April 2022 it jumped 29% to £1.62. Most recent data points to prices of c.£1.48, a year-on-year decline of 9%.
Food price inflation is one area which is garnering a lot of interest. That component of CPI increased 18% year-on-year in February, a monthly jump of 2.1%. As UBS Chief Economist Paul Donovan explains in his daily and longer notes, we are now in profit-led inflation. He demonstrates this with the mark-up on milk i.e., the UK retail price of milk less the farm gate price. Typically, this was 25-30p but in recent months it has risen to 41p or an increase of 37%. Our Head of Rural Research, Andrew Shirley, wrote about this milk movement earlier in the month. The latest read from the British Retail Consortium unfortunately means there may be more on this to come particularly due to recent shortages of vegetables.
So, what does this mean for interest rates?
February’s inflation figures cemented the Bank of England’s (BoE) March decision to raise base rate from 4% to 4.25%. The next read may indeed prove critical. The MPC will announce their decision on 11 May – we will have only March’s read by then with the April figures due on 24 May.
If inflation goes up in March, then again, they will have no choice and rates will rise. If they go down that could reinforce the view that February was a blip. The problem the BoE faces is that their policy movements don’t have as much sway over profit-led as demand-led inflation. The Bank’s Governor, Andrew Bailey, has repeatedly said however that they will not hesitate raising rates if inflation proves persistent.
The market is currently pricing in a rate peak of 4.5% - one more 25 bps move - and as my colleague Tom Bill has written about the mortgage market has moved, up down and sideways over recent months due to numerous factors. He quotes Simon Gammon, Head of Knight Frank Finance, that:
“Rates should fall in the longer-term but until we get to the point where inflation and the bank rate have clearly peaked, I suspect lenders will keep tip-toeing up and down with their rates depending how confident they are feeling at the time.”
The BoE will be weighing up the inflation figures with labour market, sentiment and liquidity in the banking sector and overall economic health. Afterall, the BoE has a dual mandate: price stability and financial stability. The fallout for UK institutions has been limited and Bailey has said that the UK financial system was “resilient, with robust capital and liquidity positions, and well placed to support the economy” so price stability will remain at the forefront.
However, “it takes over a year before monetary policy actions have their peak effect on inflation”, and given the prevalence of fixed-rate loans in recent years this time frame may have extended. The current hiking cycle began in December 2021 and gathered pace in August when the hikes went from 25 bps to 50bps, with 75 bps in October 2023. We are 15 months into the start but have some way to go to feel the more sizeable hikes. Therefore, a pause may be needed to assess the real impact. The OBR forecast inflation will fall to below 3% (within the BoE target range) by the end of the year and that’s with rates peaking at 4.25% which further adds weight to the argument.
I finish as I started, one read doesn’t make a trend but with the recent data on food prices we can’t discount the pressure this will feed through in March’s read. It is likely inflation will resume its downward trajectory in April so we may see at least one more 25 bps move in May. The main takeaway is that until the BoE has a meeting without hiking rates, we cannot know for certain where rates will peak but, in my opinion, there are some clear reasons for them to take a breather.