This week brought some welcome news from the US as inflation in the world’s largest economy slowed to 3% in June, down from 4% a month earlier. This is the lowest inflation reading since March 2021, and though the fall back is at least partly driven by base effects, it is hard not to see this as a success by the Federal Reserve in its crusade against inflation. Core inflation has also fallen, though at 4.8% it remains uncomfortably high. While a further 25 basis point rate hike is still firmly priced in for the Fed’s July meeting on the 26th, it seems possible that this might be the last increase in the current rate hike cycle – a ‘soft landing’ which sees inflation coming down without a painful increase in unemployment might just be within reach.
Can we hope for a similarly benign end to inflation here in the UK? The current mood certainly wouldn’t suggest so and indeed, the latest round of inflation and labour market figures doesn’t provide much encouragement. Core inflation continues to trend upwards rising to 7.1% in May, and wage growth in excess of 7% also remains too strong for the Bank of England’s taste. However, there is a risk that excessive focus on short-term indicators obscures the bigger picture.
Much of the current inflationary stubbornness was predictable if one paid attention to the underlying dynamics. Indeed, already three months ago, we forecast that CPI inflation in Q2 this year would average 8.5% – an estimate that has only marginally been revised to 8.6% in our latest forecast.
Looking ahead we can be quite certain about the mechanical impacts of falling energy prices on inflation, given that predictions for the July and October price cap have hardly fluctuated over recent months. Based on this, we expect inflation in the ‘housing, water and fuels’ category to halve in July, falling to just under 6% before the rate turns negative in October, at around -3%. Meanwhile, falls in petrol prices, that have attracted a lot less press coverage than similar sized increased last year, mean that pump prices are down by a quarter year-on-year, also helping to cool transport inflation. We forecast inflation by year end to stand at around 4.5%, which would mean that the Chancellor will have reached his goal of halving price growth – though some might question his specific contributions to this feat.
The latest labour market release showed that the unemployment rate has continued to edge upwards gradually but consistently since the summer of last year. Vacancies are falling sufficiently to lower the vacancies-to-unemployment ratio, which the Bank of England observes to gauge labour market tightness. Other labour market measures, such as the KPMG/REC survey also show signs of a looser labour market with the supply of workers in June increasing at the sharpest rate since December 2020. Given the lagging nature of labour market indicators and the UK’s difficulties in expanding labour supply back to pre-Covid levels, we will need to wait and see how quickly these developments translate into easing wage pressures, though various leading indicators show that we are heading in the right direction.
Lastly, we also need to factor in the impact of higher mortgage rates on households. The Bank of England’s latest Credit Conditions Survey showed that mortgage defaults, as reported by lenders, jumped to their highest level since 2009 in Q2. As more people roll off their old mortgage products and onto newer loans with significantly higher interest rates, defaults will likely increase further. Even if a default can be avoided, borrowers will see substantial cuts to their household disposable income which should cool demand in the coming months.
Looking through the latest data release – and most likely also the upcoming inflation print which will provide little to no relief – it seems that the economy is cooling in a way that should help inflation fall further.
It would be facile to say that the Bank of England should avoid conducting monetary policy in the rear-view mirror. The reality is that the central bank is not only fighting against inflation but also to regain its credibility. A sensible compromise could be found in a more moderate pace of interest rate rises assuming that slowing inflation, a looser labour market and waning consumer demand will shift the outlook sufficiently in coming months. The outstanding impact of the rate hikes that has yet to work its way through the system might well be enough to tip the economy into recession by then, in line with our central forecast which sees two quarterly contractions in GDP for Q4 this year and Q1 next year. This could be enough to convince the Bank of England to hold off on further rate rises after that, which is why we stick to our forecast that the bank rate will peak at 5.75% in November this year. In summary, it seems unlikely that the UK economy will get away with a soft landing as the US might just be about able to pull off, as the reluctancy by the Bank of England to raise rates earlier and more decisively has likely contributed to the inflation problems we see today. But the Bank of England will soon need to decide whether it prefers a shallow contraction with a longer path back to the 2% inflation target, or a more aggressive approach that might deliver lower inflation faster but at the cost of turning a smaller dip into an economic crash.
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