Columbia Threadneedle Investments: Has the Bank of England got it all wrong?

Last week the Bank of England (BoE) raised base rates to 5.25%, the 14th increase since they started tightening policy in late 2021. It has not been a successful time for the Bank. The UK has the highest inflation of any major country and growth here is weak. The Bank is now suggesting that whilst rates may be close to a peak, there are signs that inflation is becoming embedded in the UK so rates may stay high for a long period. Indeed, they suggested that keeping rates at their current level for two years could be a route to getting inflation back to their 2% target. Bad news indeed. Yet the Bank’s forecasting has been so bad that they have called in Ben Bernanke, distinguished former chair of the US Fed, to help.

In this week’s Market Perspectives, we look at the prospects for the UK and suggest that the outlook for interest rates might not be as bad as the Bank of England suggests.

Let’s start with the outlook for UK inflation. Yes, it’s higher than many forecasters, including me, had expected. I think much of the excess is due to Sterling weakness last year. This takes time to feed through and according to my estimates, accounts for as much as 2 percentage points of current inflation. Sterling has been stronger of late so that 2% is set to disappear and turn into a favourable influence next year, reducing inflation by as much as 1 percentage point.

Second, there are clear signs that the labour market is weakening and that this will translate into slower pay growth. Unemployment has already edged up from its lows a year ago and is set to rise further in the next few months. Survey data suggest that wage inflation is set to fall. The BoE set great store by wage inflation, on a three-month annualised basis, which has been high. But those figures include April’s whopping 10% increase in the living wage – a clear one-off. As the living wage has risen relative to other pay, it affects more and more workers. The latest increase affects 2 million directly. To annualise figures including that increase is not just double counting, it’s quadruple counting. Nowhere in the Bank’s forecasts or analysis do they mention this.

A weaker labour market and receding pressure from last year’s Sterling weakness, are good reasons to expect lower inflation. The dramatic turnaround in household energy bills is another; from an increase of 200% in the latest annual inflation figures to a decline of 15% or so in the next, with a further fall due in in October.

Lower headline inflation should feed quickly into lower pay settlements given that the labour market is weakening.

So, what does all this mean for mortgage rates, base rates and Sterling? The Bank may or may not raise rates again but either way we are close to a peak. The markets are pricing in a slow further increase in base rates, toward 6%, which does not peak until this time next year. I think UK inflation will be on a firm downward trend well before that. And remember, the impact of rate hikes already in the system will be working through to sharply higher mortgage bills as fixed rates deals are re-set.

I expect UK base rates to be falling, not rising, next year. They won’t go down anywhere near the recent lows but could fall to 4%. That would mean lower mortgage rates, but again, nowhere near the recent lows. Sterling may weaken as a result but only marginally as I expect US rates to be falling by then too.

The BoE has another policy tool, one that gets relatively little attention; quantitative tightening (QT). This is the process by which the central bank sells off the government debt bought up during Covid when base rates were on the floor. The BoE has been by far the most aggressive of all the central banks in its QT policy and this has pushed gilts yields higher, increasing the debt service bill and pressurising government finances. I think they should consider slowing the pace of QT but the Bank is floating the idea of moving in the opposite direction.

So it’s been a tricky time for the BoE. That won’t change any time soon but if I’m right and inflation starts to fall significantly, they will be able to claim that their tough policy stance has worked. That would be a great relief in Threadneedle Street.