The US Federal Reserve has done it. The European Central Bank has done it. Now the Bank of England must decide whether to follow suit and opt for a bigger than usual rise in official borrowing costs when it meets on Thursday.
After edging rates up by a quarter-point at a time, the financial markets are betting that Threadneedle Street’s monetary policy committee (MPC) will announce a 0.5 percentage-point jump this time, something that has never happened since the Bank was granted independence in 1997.
The previous time interest rates were raised by such a margin, John Major was the prime minister, Ken Clarke was the chancellor and Eddie George was the Bank of England governor. That was back in 1995, when the Treasury still had the final say over interest rates.
If the Bank does break new post-independence ground, it will not just be because the annual inflation rate is at a 40-year high of 9.4% and expected to rise further over the months ahead. Nor will it be simply a matter of playing catch-up after repeatedly underestimating price pressures, even though that is a factor. This time last year, the MPC was forecasting that inflation would peak in late 2021 at just 4%.
Rather, the jump will be because the Bank’s fear of inflation becoming embedded in the economy outweighs concerns that the economy is about to enter recession or, indeed, may already be in one. David Blanchflower, a former MPC member, has said he believes the UK is in the early stages of a recession that began a few months ago.
What makes the committee’s job more difficult is that the economy is giving off mixed signals, as is often the case at a key turning point. Unemployment is back to low levels last seen in the 1970s and there are record job vacancies.
Some companies – such as the supermarket chain Aldi – have raised pay for their workers twice in the past year in an attempt to hold on to staff.
Others, including the housebuilder Taylor Wimpey, the bank HSBC and the energy company Shell, have announced one-off payments to help staff through the cost of living crisis.
The tightness of the labor market concerns the Bank, since it conjures up memories of the 1970s, when prices and wages chased each other higher until inflation reached a post-second world war peak of 25%.
Prof Stephen Millard, of the National Institute of Economic Research, argues interest rates need to go up from 1.25% to about 3% if inflation is to be brought back on track, but he thinks talk of a 1970s-style wage-price spiral is overdone.
Median pay settlements averaged 4% in the three months to June and even with bonuses and one-off payments on top, Millard only expects earnings growth of 6% this year – well below the inflation rate. Wage growth is high by recent standards, he says, but not high enough to create an inflationary spiral.
The Bank’s decision will also be affected by what it thinks is happening to underlying inflation, as measured by consumer prices excluding fuel, food, tobacco and alcohol. Here, the trend has been encouraging, with core inflation falling for two months in a row from 6.2% in April to 5.8% in June.
Of more concern will be the steady increase in service-sector inflation, up from 0.7% in June 2021 to 5.2% in June. That will be seen as a sign of price pressures being generated in the domestic economy, rather than being imported from abroad.
Chris Williamson, the chief business economist at the ratings agency S&P Global Market Intelligence, says surveys of manufacturing and services businesses show the economy is heading for a recession and that the debate is about how long and deep it will be. He says the Bank should be aware that a 0.5% increase in interest rates and a signal that the base rate is heading to 3% will shove the economy into an even deeper recession.
Williamson is concerned that many of the indicators showing the economy performing well could reverse quickly should interest rates rise quickly. He warns this “bullwhip effect” could mean that business closures, which have remained low during the pandemic, become widespread, while unemployment, which has steadily failed over the past year to a 48-year low, begins to rise.
The housing market, which has proved resilient since the beginning of the pandemic, could also begin to weaken and prices could begin to fall, pushing some households into negative equity.
Tim Bannister of the online real-estate portal Rightmove says first-time buyers are facing average monthly mortgage payments 20% higher than at the start of the year, due to rising interest rates and asking prices. Meanwhile, existing homeowners, many of them nearing the end of a fixed-rate mortgage, are having to pay higher monthly bills.
“With each jump in interest rates, homeowners are contributing approximately 1% extra of their gross salary on average towards a mortgage, and a 0.5% increase in the base rate would take average monthly mortgage payments towards 40% of their salary,” he says .
Another sign of an impending slump can be found in the warehouses of retailers, manufacturers and construction companies. For much of the past year, businesses have stockpiled raw materials and goods that are in short supply to guarantee they can fulfill contracts and supply customers.
However, figures from the US show a collapse in consumer demand has left companies with mountains of unsold clothes, household goods and furniture. Inventories were high to support sales a few months ago. Now warehouses are clogged with stuff that must be offloaded at a discount, with few potential buyers.
Williamson says the problems facing Walmart and Costco in the US will also apply to large retailers in the UK and across Europe.
Krishna Guha, from the investment bank advisory firm Evercore, expects the Bank to “join the global trend for supersized rate hikes” with a half-point increase to 1.75%, albeit with some reluctance due to the pronounced slowdown in the economy.
Like most other analysts, Guha will be looking for clues as to where – with the UK on the brink of stagflation – the Bank goes next.