This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.
Inflation is back to the target of 2 per cent at last. But don’t expect a cut in interest rates from the Bank of England’s Monetary Policy Committee, which meets on Thursday. All the signals are that it will hold off at least until its next meeting at the beginning of August.
So how come interest rates were put up to bring inflation back to target, but now it’s on target, the Bank is not going to start bringing rates back down? From a political point of view, it must be a bit galling for the Government. Had it waited a bit longer before calling the election it would have been able to say that both that it had delivered on inflation, and that the benefits in terms of lower rates were starting to come through.
From an economic point of view it would be a relief to businesses, consumers and home buyers to see that the corner had clearly been turned. We all need a bit of a lift.
But, standing back, it may not make that much difference on either count. Voters have made up their minds, and as long as rates do come down in August, waiting another six weeks is not such a big deal.
We all know what is going to happen, and you can see signs that people are anticipating the decline in rates. For example, the housing market seems to have perked up a bit, with the Land Registry reporting that prices are climbing again and in April were up 1.1 per cent on a year ago.
The CPI doesn’t tell the whole picture
In any case, there is a respectable reason for thinking that while interest rates will come down a bit in the coming months, they will remain relatively high for the foreseeable future. There is concern that headline inflation has dipped as a result of one-off factors, and that underlying inflation is still a real concern.
That 2 per cent figure for the CPI hides huge swings in prices. Electricity is 21 per cent cheaper than it was a year ago; gas is more than 37 per cent down. But package holidays are 9 per cent up, and rent 7 per cent up. New and used cars are down nearly 5 per cent, but the cost of insuring them up 17 per cent.
The overriding point here is that goods, taken as a whole, are actually a tiny bit cheaper than they were a year ago, while services are nearly 6 per cent more expensive. But – and this is the worrying bit – goods prices are not going to keep falling – there is unlikely to be another 21 per cent fall in the price of electricity over the coming year. Meanwhile, services will go on climbing, because they use a lot of labour and pay rates are strong. The latest figures from the ONS show that public sector pay is 6.4 per cent year-on-year, and private sector pay up 5.8 per cent.
The danger is that inflation does indeed stay around 2 per cent through the summer and autumn, but then starts to climb towards 3 per cent or more next year. For what it is worth, the Bank calculates so-called “core” inflation, which excludes food, energy, alcohol and tobacco (even though most of us would consider at least two of those pretty core elements in our day-to-day lives), and that is at 3.5 per cent. Unless that comes down, inflation will indeed get stuck at something close to 3 per cent, which will lead to tough questions as to whether the 2 per cent target should be eased slightly on a temporary basis.
The global picture
This will be a global debate, because much the same pattern of falling goods prices but rising services prices is happening right across the developed world. There are fears in the US that the refusal of the Federal Reserve to cut rates will tip the economy into recession. And there are concerns in Europe, where the European Central Bank did reduce rates a couple of weeks ago, that there won’t be any more cuts for quite a while.
So what will happen here? My best guess is that the MPC (Monetary Policy Committee) will probably cut rates in August and if it doesn’t, it will almost certainly do so in September. Then there will be one more cut by Christmas, bringing the Bank’s rate, currently 5.25 per cent, to 4.75 per cent. But beyond that, rates will be sticky. It is, as I say, a guess, but they are likely to be over 4 per cent right through 2025 and probably beyond. The only thing that would lead to significantly cheaper money would be a global recession, so anyone hoping for a lower loan rate should be careful what they wish for.
It’s a troubling prospect of course, because the only way of getting inflation securely back to 2 per cent without some sort of recession is a sharp rise in the efficiency of the service industries. That is the huge challenge for the next government here and for the others right across the developed world. Meanwhile, let’s be grateful that the beast of inflation has for the time being been pushed back into its cage.
Need to know
It is a seductive notion that the central banks could tolerate slightly higher inflation for a while if it meant that growth would be faster. A number of people have made this point. Andy Haldane, former chief economist at the Bank of England, argued that the Bank should avoid overdosing the economy with high rates and accept above-target inflation. Mohamed el-Erian, now president of Queen’s College in Cambridge, and previously chief executive of PIMCO, the huge US bond investment managers, thinks that the 2 per cent target is “totally arbitrary” and has called on the US Fed to cut rates sooner rather that later. However the Fed chair, Jerome Powell, has made it clear that people should expect only one cut in US rates this year.
“We’ll need to see more good data to bolster our confidence that inflation is moving sustainably toward 2 per cent,” he said at a news conference after the most recent Fed meeting ended.
There will be a lot of political pressure on the central banks in the months ahead. Property developers like cheap money, so were Donald Trump to become the US president, you could obviously see that happening in America. You could certainly see it happening in France were the right to win there too – something already causing jitters on the bond market – though of course it’s the ECB that sets eurozone interest rates. It’s not hard to see the new Labour government seeking lower rates either.
Looking ahead, there are two questions: One is whether central bank independence is sufficiently embedded to hold. For the ECB that is pretty much a given. Given what happened when Liz Truss tried to undermine the system of fiscal discipline by sidelining the Office for Budget Responsibility, I think the Bank of England is safe for a while yet. But in the US, there could be a wobble in the event of a Trump victory.
The other question is how to tackle the global debt load. There is a great temptation to try to inflate it away, as the UK did in paying for the Second World War. But the bond markets are less supine than they were in the 50s and 60s – at least I think they are, because the experience of the recent bout of inflation has been a chilling lesson for bond-buyers. Frankly, I don’t trust governments to pay their debts if there’s any way they can avoid doing so.
Having lived through the greatest burst of inflation in the UK in the past 700 years in the 70s and 80s, and now another deeply damaging one, I think that suspicion is fully justified. Have a look at the Bank of England’s wonderful Inflation Calculator here and play around with some numbers. I think you will see what I mean.
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.