Sunday, July 23, 2023
The window for further rate rises is closing
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

It probably did not happen, more’s the pity, but I have in mind a raucous singing of a version of the great football song Three Lions around the Bank of England’s marble halls, but instead of “It’s coming home”, this version has “It’s coming down”, with an echoing chorus from the Treasury and Downing Street down the road in Westminster.

Inflation is indeed coming down, as we learned a few days ago. And, for the first time in more than four months, the figures surprised on the downside. It had to happen sooner or later, and it has.

I know what you are thinking, that one swallow does not make a summer, and that there is nothing to celebrate about an inflation rate which, at 7.9 per cent, down from 8.7 per cent, is still nearly four times the official 2 per cent target. The “core” rate, excluding energy and food, is at 6.9 per cent still very high.

It is hard to celebrate too when food price inflation is running at 17.4 per cent. As I wrote not long ago, for many people the inflation dragon will only be slain when food price inflation is back to its (low) normal. Not for the first time, Russia is making things difficult, its decision to pull out of a deal guaranteeing Ukrainian grain shipments across the Black Sea pushing prices higher on international markets.

And yes, I also know pay has been falling in real terms, though the measure official statisticians use to calculate this, CPIH (the consumer prices index including owner-occupiers’ housing costs), has inflation now running at 7.3 per cent, the same as the growth in regular pay.

I also must report, having highlighted it when it was rising, that consumer confidence has suffered a setback. The latest reading from GfK, on Friday, showed a six-point fall, and is back down to where it was in April. People are gloomier about most things, except savings, where they are a touch more cheerful.

The big point, however, is that the path to lower inflation is now much more clearly signposted. Inflation fell sharply last month because the monthly rise in consumer prices in June this year, 0.1 per cent, was a pale shadow of the 0.8 per cent monthly rise a year earlier. There are many more favourable comparisons to come when the data comes through in the second half of the year.

This is not, plainly, just a UK phenomenon. US headline inflation has dropped to 3 per cent, the eurozone’s to 5.5 per cent. Spain, usually thought of as being a bit flaky on inflation, now has a rate below 2 per cent. So does Switzerland, not usually thought of as flaky.

Suddenly, Rishi Sunak’s promise to halve inflation by the end of the year no longer looks rash, though his claim that “the plan is working” is stretching it. Goldman Sachs, one of his former employers, predicts a 4 per cent headline rate by December. It, along with pretty much every other set of Bank-watchers, expects a further increase in official interest rates on August 3, the next decision. Before last week’s figures, markets thought that decision would be for a second successive half-point hike. That remains possible, though many have now switched to expecting a quarter-point, 25 basis points.

On one hand, the inflation figures were comforting. On the other, wage growth remains too strong, as shown by the most recent figures earlier this month. For the many people reading this who cannot understand why the Bank should be raising rates at all to bear down on pay rises when, until now, wages have been falling in real terms, let me explain in a way the Bank itself struggles to do.

The issue here is what are known as “second round” effects. You can take your choice about what were the first-round effects which gave us high inflation, either previously loose monetary policy, including a big expansion of quantitative easing (QE), or a series of external shocks. Those include the re-opening of the world economy after the pandemic, amid continuing supply chain difficulties and, most importantly, the energy and food price shock arising from Russia’s invasion of Ukraine. Or, most probably, a combination of all these things.

The reason the Bank worries about pay is not because it thinks it was the cause of inflation but because it fears the second-round effects, in other words big wage increases now will lock in higher than acceptable inflation. There is clearly no way annual growth in average earnings of 7 per cent is compatible with 2 per cent inflation in the medium term.

Where does all this leave us? Though I wish it were not so, there may not be much that can be done to prevent another small rise in interest rates early next month. After that, any further rate hikes look highly questionable. The Bank has been supported by the government during this rate-hiking period, but has struggled to convince the public it is doing the right thing, even when inflation was higher and rising sharply.

That support will be much harder to garner if it were to persist with raising rates even as inflation falls sharply. The Bank may cite elevated core inflation and wage growth, but both will come down in time. These are the circumstances in which it could and should allow the medicine it has administered to take effect. The GfK consumer confidence survey shows people are more worried about the economic outlook. The Bank will win no friends, and lose credibility, if it were to push the economy into recession with excessive rate hikes even as inflation were falling.

On that note, despite my best efforts, just about every other email I get asks why the government does not raise taxes to bring down inflation, instead of relying on the Bank and interest rates. These emails are endearing, because they demonstrate that stealth taxation works in fooling people, the point being that direct tax – income tax and national insurance – is already going up hugely because of the freeze on allowances and thresholds, and corporation tax has just gone up too.

If that leaves indirect tax, notably VAT and excise duties, that would be a terrible instrument to use. Not only would any increase push up measured inflation, but as the Office for National Statistics has just pointed out, it would hit those on the lowest incomes hardest. Over 28 per cent of what it calls the “equivalised” disposable income of the poorest fifth of households goes on indirect taxes, compared with 9 per cent for the richest fifth. Those struggling most would be hit hardest. Indirect taxes are a significant source of inequality.

What about taxing the wealthy? There may be arguments for doing so but they have nothing to do with reducing inflation. Soaking the very rich would have only a marginal impact in reducing demand in the economy, and not just, or mainly because they are adept at avoiding tax. There are not enough of them to make a significant difference.

We have to stick with interest rates, but we also have to hope that we are approaching the end of that journey.