MPC unconcerned about spike in inflation -
inflation UK

MPC unconcerned about spike in inflation

Publication of the latest MPC meeting notes has prompted a heated debate amongst economists and investors. While the MPC has mentioned on numerous occasions we are in “uncharted territory”, recent growth in the economy has surprised even the most optimistic of analysts. A few months ago, there were serious concerns that the UK economy would struggle in the aftermath of Covid-19. Now the main problem seems to be inflation which is at least a couple of months ahead of Bank of England forecasts.

Currently, the MPC appears unconcerned about the strong inflation numbers and the upward revision of GDP growth. However, some experts believe that the relaxed tone of today’s notes could be replaced in the not-too-distant future.

Prospects for the UK economy

If we cast our minds back to the May MPC meeting, members suggested that UK economic growth in the second quarter would hit 4.25%. There was always going to be a jump in GDP growth as COVID restrictions were relaxed. Even against this backdrop, a 1.25% increase in forecast second-quarter growth in just a month is a significant event. We wait to hear any revisions to annual growth expectations for 2021, but second-quarter growth should hit 5.5%.

There are serious concerns that the UK economy could overheat, assuming that COVID restrictions are finally lifted in July. The spectre of inflation has long been a grey cloud over the ongoing recovery, and nothing has changed as yet. To be fair to the MPC, they have held their nerve on numerous occasions recently with a focused path to recovery. The latest figures suggest this mindset could be challenged and the journey to recovery revised. Time will tell.

Unemployment in the UK

On the subject of unemployment, very little has changed with regards to the short to medium-term outlook. The MPC May revision of expected peak unemployment has been trimmed from 5.5% down to 5.4%. This is against the reduction from 7.75% down to 5.5% in May – another indicator of how strong the economy is. Even though the furlough system has had its fair share of critics, there is no doubt it has secured many jobs which would otherwise have been lost.

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The following graphic, courtesy of the Office for National Statistics, illustrates the sectors weaned off the furlough system and those still reasonably dependent. Retail, construction and manufacturing are vital elements of the UK economy, and the reduction in furlough numbers reflects the ongoing recovery. The hospitality and entertainment sectors are still struggling due to continued restrictions on crowd numbers.

chart showing ons data

It will be interesting to see whether, as expected, the furlough system is wound down towards the end of September. While there are concerns the hospitality and arts sectors will struggle for some time to come, the expected lifting of restrictions in July will give a much-needed boost.

Inflation in the UK

While the MPC has been keen to focus on long-term inflation trends, discounting short-term spikes to a certain extent, this strategy is being tested. Just last month, the MPC forecast that UK inflation would peak at 2.4% in the final three months of 2021. Oh, how things can change in just a month! They were also waxing lyrical about an expected fall back to around 2% in early 2022 – a return to the 2% long-term inflation target.

While the MPC has warned about “premature tightening” of fiscal policies, all eyes will be on inflation over the next few months. Last month we saw UK inflation increase to 2.1%, the highest level in nearly two years. In reality, this is a consequence of the various COVID lockdowns. Growing consumer demand, an inability to bring excess capacity online quickly enough and pent up demand for raw materials has pushed prices higher.

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There is every chance that this seesaw effect will eventually balance out, reduce inflation and bring demand down to more natural levels. However, against the current backdrop, the MPC has been forced to revise inflation targets in the short term. They now believe that inflation will peak at around 3% later in 2021 and then fall back in early 2022. If inflation remained stubbornly high, we could see an earlier than expected increase in interest rates.

UK interest rates

The MPC committee, led by Governor of the Bank of England Andrew Bailey, voted unanimously to keep UK interest rates at 0.1%. Interestingly, while there remains pressure on inflation, which could prompt a surprise increase in base rates, the consensus seems to be that the next base rate increase will occur in August 2022. This is two months later than the previous consensus amongst economists. Publication of the MPC meeting notes saw sterling drop against the dollar and the euro, supporting the theory of a delayed increase in base rates. Against the backdrop of strong inflation, this is a difficult one to explain!

It looks as though the next few months will be crucial for the UK economy and especially inflation. While the MPC is constantly warning about the damage that “premature tightening” could do to the economy, inflation is a serious issue. There are also growing concerns about the ongoing £895 billion stimulus programme. Outgoing MPC member, Andy Haldane, has been openly discussing his concerns about inflation. Indeed he believes that inflation pressure has created:

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“The most dangerous moment for monetary policy in almost 30 years”

International challenges

Looking overseas, it is not just the UK currently experiencing more robust than expected inflation. US inflation increased from 4.2% in April to 5% in May, prompting the Federal Reserve to openly discuss a potential increase in US base rates in the short term. This is why many people believe that the Bank of England will need to change tack and take a more aggressive approach to the threat of high inflation.

There is no doubt that the outlook in the UK and internationally is showing signs of improvement. Covid-19 vaccination numbers continue to rise, protection has been confirmed against the latest variants, and international travel is back on the agenda. There is light at the end of the tunnel, although there may still be a few blind corners and bumps in the road to navigate.

Bank of England shows poker face

While economists and investment analysts continue to voice concerns about the sharp increase in inflation, the MPC is determined to look at the longer picture. Amid fears that premature fiscal tightening could derail the short to medium-term UK economic recovery, there is no sign of an increase in base rates as yet. This will most definitely change if inflation continues to rise above and beyond 3%. However, the MPC is content to take a reactive rather than proactive stance at this time.

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