The Bank of England Troubled by Ongoing Inflation Issue

The Monetary Policy Committee of the Bank of England may be feeling like the underachieving student in comparison to its counterparts. While the US Federal Reserve and the European Central Bank have signaled a hawkish stance, signaling the end of their interest rate hikes, it will be a challenge for the MPC to convince markets that the UK is on the same path.

In terms of headline inflation, the UK is experiencing higher levels compared to the US and eurozone. The OECD predicts that the UK will have one of the highest price growth rates among major economies this year. Recent data on inflation and wage growth suggest that the BoE has more work to do.

The persistently high inflation in the UK is becoming a growing concern. Core inflation, which measures underlying price pressures, has eased in the US and Europe to just above 5% in May. In contrast, the UK saw a sharp increase in core price growth in April, rising to 6.8% from 6.2% in March.

Wage growth, which contributes to inflation, is showing resistance. Advertised wage data collected by Indeed, an employment site, indicates that wage growth has flattened or declined in the EU and US after peaking in 2022. However, the UK continues to experience rising wage growth and new records. This implies that the risk of a wage-price spiral, where high inflation drives demands for higher pay, is higher in the UK than in the US and eurozone.

The BoE faces some unique circumstances. The UK has faced both a significant energy shock similar to the eurozone and labor shortages like those in the US. European natural gas prices have fallen since last year, leading to a quicker decline in energy inflation in some eurozone countries. Differences in consumer energy prices contribute to this disparity and will eventually affect the UK. The UK’s strong job market has also been influenced by idiosyncratic factors such as high levels of long-term sickness, early retirement, and changes to immigration rules. Brexit trade barriers may have also contributed to soaring food prices, as per a study by the London School of Economics.

Nevertheless, the central bank has underestimated the persistence of inflation and the extent of labor shortages. Inaccurate forecasts erode confidence in the BoE’s ability to maintain price stability. Following recent data shocks, financial markets anticipate interest rates to reach 5.75% by the end of the year, up from the current 4.5%. The impact on mortgage seekers and those transitioning from fixed rates is substantial, as rate expectations influence loan pricing. Banks have started withdrawing mortgage products and increasing borrowing costs.

The Governor of the BoE, Andrew Bailey, appeared before a House of Lords committee on Tuesday for an inquiry into the central bank’s performance, resembling a student being reprimanded by the headmaster. The bank subsequently announced a review of its forecasting errors, indicating a willingness to learn from its mistakes.

At the upcoming meeting, a 25 basis point rate increase seems reasonable. A 50 basis point increase, as advocated by some, might be too jarring for the markets. However, the central bank’s communication will be just as crucial as the rate hike. It needs to convince the public that it acknowledges its recent errors to maintain its influence over rate expectations. The bank may also want to use more assertive language to demonstrate its commitment to bring inflation back to 2%. It must take control swiftly.