The May Monetary Policy Committee (MPC) meeting brought about the much-anticipated increase in UK base rates, but there were still some surprises. The committee members have turned negative on the UK economy and acknowledge there are risks in increasing the base rate. In all honesty, their hands are tied somewhat with inflation set to hit double digits and no let-up in the increasing cost of energy. However, increasing the cost of mortgages and borrowing amidst the current cost of living crisis is a risk, even if calculated against out of control inflation.
By a majority of 6-3, MPC members voted to increase rates by 0.25% to 1%. However, those members in the minority favoured a 0.5% increase which would have taken base rates up to 1.25%. This is the fourth consecutive MPC meeting to deliver a rate increase. After spending the latter part of 2021 and the early weeks of 2022 sitting on their hands, the MPC now can’t raise interest rates quickly enough!
Prospects for the UK economy
It is safe to say there has been a sharp downturn in the UK economy in recent weeks. The prospect of further interest rate increases and out-of-control fuel inflation have placed household incomes under colossal pressure. However, many experts believe that higher interest rates will have little impact in the short term until the energy supply issue and subsequent price rises are addressed. With further interest rate rises expected in the short to medium-term, the Bank of England is doing everything it can to avoid the R-word – recession.
Previously, the Bank of England had expected the UK economy to grow by 1.25% during 2022. However, the May MPC meeting notes show a sharp downward revision in forecasts, seeing the UK economy contract by 0.25% by the end of 2022. While a recession is recognised as two consecutive quarters of contraction, further weakness in the UK economy would make this a real possibility. Furthermore, forecast economic growth for 2023 has also been revised downwards from 1% to 0.25%, suggesting there may be more pain in the short term.
We know that some of the MPC members favoured an even more aggressive increase in base rates. Consequently, it is difficult to see any good news on the horizon.
Unemployment in the UK
Even though we have seen recent encouraging news on unemployment, down to 3.8% in the three months to February, there are challenging times ahead. The February figure beat expectations of 3.9%, and unemployment is likely to fall further in the immediate future. Then we move on to the medium-term prospects, which are very different!
In the March MPC meeting, the Bank of England forecast that unemployment would start to rise in 2022, hitting a high of 5% by 2025. However, indications today suggest that unemployment will be slightly over 5% by 2024 amid concerns about flat GDP growth in the second quarter of 2022 and consequent falls in the months ahead. Moreover, these forecasts are based on an expected increase in base rates to as high as 2.5% by mid-2023. When you consider the reluctance of MPC members to increase interest rates just a few months ago, an increase to 2.5% by mid-2023 would be astounding.
Inflation in the UK
It is safe to say that the MPC is behind the curve when it comes to inflation forecasts in the short to medium-term. Each of the previous months has seen an upward revision which has turned out to be conservative, to say the least. In March, the MPC suggested inflation would peak at 8%, amid concerns of a double-digit spike. The latest forecasts indicate that inflation will hit 9% in the coming months and a staggering 10.25% by the end of 2022. It seems that the MPC has finally woken up to the financial dangers many experts have been discussing for months. Can we expect any further upward revisions in the short term?
While there is no doubt that the increase in the energy price cap in April has impacted consumer spending, a further rise in October could be devastating. Experts predict that household bills could hit £2800 a year by 2022. Amidst this, there are still supply issues regarding food, goods and services, which have also fed inflation. Increased borrowing costs, higher goods prices, and rising unemployment will likely see UK economic growth “slow sharply”.
Inflation is forecast to peak in 2022, falling back to 3.5% in 2023 and 1.5% in 2024. However, confidence in the Bank of England MPC is low at the moment. What would happen if the Russia-Ukraine conflict lasted for several years?
UK interest rates
It was telling that a minority of MPC members voted in favour of a 0.5% increase in base rates. While the majority won the day with a 0.25% rise, might this indicate things to come? Interest rates currently stand at 1%, and the Bank of England is basing its current economic forecasts on a rate of 2.5% by mid-2023. While expected to fall back in the latter part of 2023, this would mark a significant increase in borrowing costs over the last 18 months.
The reality is that a rise in interest rates is the most basic of tools available to the MPC and one they are now being forced to use. Supply chains and the employment market were significantly disrupted during the Covid pandemic, eventually leading to higher wage inflation and increased cost of goods and services. This phase of the recovery is only now coming to an end. Hence forecasts for a further reduction in unemployment before a sharp rise to more than 5%. Unfortunately, there is no way to sugar-coat this. The UK economy, consumers and businesses face a very challenging scenario with limited recovery until at least the latter part of 2023.
Interest rates rise again
Even though the MPC has been criticised for failing to increase UK base rates towards the end of 2021, not all of the challenges today were obvious. For example, the ever-rising cost of energy has had a monumental impact on consumer spending, business costs, economic growth and the employment market. However, there were signs that supply chain issues and a lack of skilled labour were already storing up inflationary pressure in the first half of 2022. Could the Bank of England have responded differently?
Whatever the thinking behind interest-rate policy over the last 12 months, we know that interest rates will rise significantly in the short term. An aggressive switch in policy by MPC members could see interest rates as high as 2.5% over the next 12 months. Those who took advantage of low fixed-rate mortgages in previous years could see a significant increase in their monthly repayments when the fixed-rate term ends. Could this be storing up yet more problems for the UK economy?