Jonathan Marriott, Chief Investment Officer
Bank of England (BoE) officials have cautioned that interest rates are likely to rise soon. At the start of this week, markets had priced in a first rate rise as soon as December. At the last Bank of England Monetary Policy Committee (MPC) meeting, two out of nine members voted to reduce the target for bond purchases but did not vote for a rate rise. While restrictions have eased, the economic disruption from the pandemic has not ended. So why, you may ask, are they talking up rates now?
The UK Government sets the Bank of England a 2% target for inflation. This is similar to many other central banks, however it is not exactly the same. If the inflation rate, as measured by the Consumer Price Index (CPI), is more than 1% higher or lower than this target, the BoE Governor has to write to the Chancellor to explain why. In September, the CPI was up 3.2% over the past year and the BoE Governor wrote such a letter. As recently as May this year, the BoE Governor wrote a letter explaining why CPI was more than 1% below the 2% target. If the BoE’s own predictions are correct, this will be one in a series of letters with inflation expected to go as high as 4% around the turn of the year.
The 2% target is set to keep inflation low and stable which is designed to help everyone plan for the future. The BoE explanation of this reads as follows:
“If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.”
Thus, inflation is used as a target to stabilise the economy. However, inflation is not the only measure of a stable economy, which may be influenced by factors beyond the BoE or Government’s control. Also, monetary policy can be slow to act and the economy is also impacted by fiscal policy complicating the judgement. The BoE interpret the target as a long-term aim and have a long history of ignoring short-term swings in inflation. Thus far, they have justified their lack of response to the post-pandemic inflation spike to temporary factors. Unfortunately for them, the transitory spike is looking like it will last a long time and peak higher than they previously envisaged.
It was clear that inflation would rise from a low base set during the shutdown last year. What was harder to predict is the disruption to supply chains with the cost of shipping soaring. Ports are clogged up with a shortage of drivers to move goods. Only this week it was reported that some ships were diverting from Felixstowe to Europe to offload their cargo. In addition, energy costs (natural gas in particular) have risen dramatically. A shortage of supply has come about as demand picked up. There are staff shortages due to many overseas workers returning home during the pandemic and as such are no longer available as business resumes. This has been further complicated for the UK due to Brexit. The Government has acted to allow additional foreign workers (such as lorry drivers) to come back to the UK, but it will take some time to alleviate the current shortages. A global lack of electronic components following factory shutdowns last year is also pushing prices higher. These are just some of the dislocations we face in a post-pandemic world and which are being experienced globally.
Different countries are adjusting at different speeds as the vaccines enable people to return to normal. In many parts of the world, restrictions remain in force. Hopefully the world will learn to live with COVID-19 and gradually get back to normal. Some industries can react faster than others. US lumber prices, which rose dramatically at the start of the year due to shortages in supply, have returned to pre-pandemic levels. However, other commodity prices remain high. We can concur with the central bankers that many of the inflationary factors we see today are transitory, and as supply chains recover price pressures will ease.
Rising input prices squeeze profit margins and can slow the economy down as demand re-adjusts. Raising interest rates generally reduces demand but does not help sort supply shortages. If inflation is primarily due to external supply shocks, then raising interest rates may make things worse for the economy. The BoE’s dilemma is further complicated by the fiscal tightening that is taking place. Various pandemic support schemes are being unwound with the Chancellor now focussed on balancing the budget. The furlough scheme has ended, Universal Credit uplift has been removed, the temporary cut in VAT on eating out has finished and National Insurance has been increased. The end of the furlough scheme alone may see unemployment rise. However, despite elevated levels of job vacancies, getting workers with the right skills takes longer to resolve. The housing sector benefitted from a temporary cut in stamp duty, but this is now over. Property prices outside London had benefitted from the shift to working from home. While property prices appeared to hold up post the stamp duty holiday, the latest survey from the Royal Institute of Chartered Surveyors indicates that price pressures are easing.
The MPC will be keen to take back the monetary stimulus and raise rates, if for no other reason than to have some ammunition if the economy slows again. They fired their big bazooka and it has largely worked to save the economy, now they need to reload. However, the fiscal tightening and the supply side nature of inflation may give them reason to take a more cautious approach, rather than only responding to the CPI data. For now, just talking up interest rates may have the desired effect. Sterling has held up despite more prolonged price pressures. The Gilt market has moved to price in rate rises, which makes it look closer to fair value than it was. Index linked gilts are priced for a long period of high inflation, and in our opinion remain expensive.
In the long run, the Chancellor and the Governor of the BoE may like to reconsider the 2% inflation target. The US Federal Reserve has a 2% inflation target, but it is less explicit, and they also target full employment. They have recently changed this to an average of 2% inflation and included an aim for full employment for minorities. They do not define “average” which gives them much greater freedom to aim for a stable economy. Without a broader, more flexible target, there is a danger that the MPC could be pushed into a rate rise that would be inappropriate for the wider economy
 Office for National Statistics/ Bloomberg/
 Bank of England: https://www.bankofengland.co.uk/
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