Michael Saunders, a member of the Bank of England’s Monetary Policy Committee (MPC), believes that UK base rates could top 2% in the next 12 months. Economic growth would seem to be the casualty in the short-term as the Bank of England looks to rein in further inflationary pressures. These comments place yet more focus on the MPC and what many perceive to be an initially slow response to inflation towards the end of 2021.
Cost of borrowing set to increase
Traditionally, economic recoveries are fed by a relatively low cost of finance, as we have seen since the pandemic. This allows consumers and businesses to borrow and spend at relatively low rates, increasing economic activity and prompting a recovery. Usually, the tap of cheap finance is only turned off when the recovery is complete and the economy can stand on its own 2 feet. However, with inflation approaching double digits, and expected to exceed 10%, further interest rate rises are inevitable.
Bank of England under pressure
While the Bank of England has raised interest rates from 0.1% in December 2021 to the current rate of 1.25%, many still believe the Bank is behind the curve. The US Federal Reserve has taken a much more aggressive approach to base rates which could see the speed of increase ramped up in the UK. In fairness, the considerable increase in energy costs was unexpected, prompted by the Ukraine/Russia conflict. On the flip side, there were signs of significant supply chain issues last year and strong wage inflation. Maybe this was the time for the Bank of England to consider increasing rates?
Could the UK economy tip into a recession?
While the May economic figure of a 0.5% increase in GDP surprised many, this switch to growth may be short-lived on the back of two challenging months. Fuelled by a surge in holiday bookings and a significant rise in GP appointments, we also saw an increase in industrial output, and the construction industry was strong. But unfortunately, the worst of the energy crisis is yet to come. Also, public and private sector pay settlements are not tracking inflation, and consumer spending is under pressure.
Economists expect disposable incomes to come under severe pressure in the third quarter of 2022, prompting consumers to rein in their spending. In addition, the growing risk of significant industrial action over the summer will subdue economic activity and place pressure on GDP. There are also legacy issues continuing from Brexit and the worst of the Covid pandemic. Today’s announcement that inflation hit 9.4% in June is a stark reminder of the enormous challenges ahead for the UK economy, businesses, consumers, and the Bank of England.
More pain is on the way
Was the Bank of England too slow to react in 2021 when inflation began to strengthen? Have recent interest rate rises been a little conservative? Under pressure from an increasingly aggressive stance from the US Federal Reserve, many are forecasting a significant short to medium-term increase in UK base rates. Energy bills are yet to peak, public sector wage settlements could prompt industrial action, and there are signs that consumers are already reining in their spending. Even the relatively strong property market could be under pressure, with mortgage rates rising, despite recently hitting a new high.