MPC resist growing calls for an interest rate rise -
MPC resist

MPC resist growing calls for an interest rate rise

The latest Bank of England MPC meeting saw a unanimous vote in favour of holding interest rates. This is despite a growing clamour for rates to rise as a means of offsetting ever-strengthening inflation. It would appear that the MPC is currently playing out a risky game of poker which could have severe repercussions for the UK economy in the short to medium term.

If the MPC approach to interest rates and inflation turns out to be correct, it will go down as a masterstroke in economic management. The vast majority of financial experts across the globe gave credence to an immediate increase in UK interest rates. This is despite the fact that initial expectations were for rates to rise between 2023 and 2024. This timescale has now been adjusted with the consensus that rates will begin to rise in 2022.

Prospects for the UK economy

The MPC has recognised the threat of the Delta variant and the potential impact on UK economic growth. However, the danger should fade in the short to medium term, having a limited effect on the UK economy. So, where does this leave current UK GDP growth forecasts?

It will be no surprise to learn that the forecasted rebound in GDP growth remains steady at 7.25% for 2021. If achieved, and the early indications suggest it will be, this will be the fastest economic growth in the UK for more than 70 years. Interestingly, the Bank of England has increased its growth forecast for 2022 from 5.75% to 6%. This level of economic growth creates the perfect scenario for strong inflation, which is precisely what we are experiencing.

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Unemployment in the UK

The recent Labour Force Survey showed unemployment at 4.8% in the three months to May. This is an increase of one percentage point compared to the end of 2019. It is essential to recognise there were still 2 million people on furlough at the end of June. As we approach the tail end of the furlough scheme, there are differing opinions as to when unemployment could peak. The Bank of England is still maintaining the peak level of unemployment will be around 5.4%. This is a significant improvement on the 7.75% expectation in the first few months of 2021.

As we move away from the furlough scheme, it appears that the recruitment industry is struggling to match available positions with workers. This will not only impact the rate of unemployment, but it is also causing a degree of disruption to the economy. This comes at a time when previous spare capacity continues to be eroded. Current strong economic growth continues to outstrip supply and create upward inflation pressure. When short-term recruitment issues are resolved, even more excess capacity will be taken out of the UK economy.

Interestingly, wage growth in the private sector showed a 7% increase in the three months to May compared to the previous 12 months. This figure is likely to peak at around 8.5% during the second quarter of 2021. In effect, wage growth in the private sector has returned to pre-Covid levels.

Inflation in the UK

It is fair to say that economic forecasts have focused on inflation over the last few weeks. There is growing concern that the Bank of England’s reluctance to increase base rates will feed the devil of inflation. The consumer price index increased by 2.5% in the 12 months to June 2021, significantly above the Bank of England’s 2% long-term inflation target. So, what does the future hold for UK inflation?

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While the MPC and independent economic forecasters were starting to diverge, they now appear to be on the same page. The MPC now believes that inflation will peak temporarily at around 4% (a considerable increase on the previous 3% forecast) in the final weeks of 2021. The rate is then expected to weaken and return to about 2% in the early part of 2022. Interestingly, just this week, the National Institute of Economic and Social Research released data suggesting inflation could peak at 3.9% in early 2022. At nearly double the Bank of England’s long-term inflation target, we would be moving into perilous territory.

We know that ongoing pent-up demand has pushed up the cost of raw materials and the price of goods/services. This comes when the recruitment industry is struggling to fill many positions, and excess capacity has been reduced of late. If these issues are to balance themselves out, reducing upward inflation pressure, we would need to see some movement sooner rather than later.

UK interest rates

The unanimous vote to leave UK base rates at 0.1% came as a surprise to many financial experts. However, there was some slight movement in the quantitive easing vote, with a 7 to 1 vote to retain the current £875 billion target. It appears that the MPC is determined to maintain support for UK businesses in what could be a tricky move out of furlough. The hope is that increased demand for workers will offset those released from furlough support, with minimal impact on overall unemployment.

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An ongoing surge in demand for financial services, one of the key service industries in the UK economy, has not gone unnoticed. This surge in spending will add further fuel to the growing strength of inflation. On balance, it isn’t easy to see how the Bank of England can maintain its current no-nonsense approach to interest rate rises. The recent increase in forecast GDP growth for 2022 is a further warning that the UK economy is robust.

We know that a pre-emptive increase in UK base rates could severely impact what is still a relatively fragile economic recovery. But, that said, it appears that inflation is the main threat to UK economic stability in the short to medium term.

How long can the MPC resist calls for an increase in base rates?

It can be easy to forget that the MPC has access to more in-depth and more detailed economic data than the general public and many economic forecasters. On the surface, it does seem a relatively high-risk approach to maintain historically low interest rates while inflation continues to rise. Unfortunately, the life of an MPC member is not easy, often pulled both ways; they can’t do right for doing wrong. It will be interesting to look back in late 2021/early 2022 and see whether this brave policy was the correct call.

While hindsight is a beautiful thing, many people believe that the signs are already there, the UK economy is starting to run out of control.

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