UK Economy: We May Need Higher Interest Rates

As the UK economy grapples with inflation, the Bank of England (BoE) is on a tightening course, having already executed 14 interest rate hikes ...

Despite the incremental tightening, there's light at the end of the tunnel; inflation finally appears to be easing its grip, dropping to 7.9% in June. Yet, a series of challenges could still dampen this optimistic narrative.

- First, the BoE's monetary policy committee (MPC) admits that its 'restrictive' policy could pose a risk to economic growth. With 14 hikes already under its belt, the BoE is walking a tightrope by trying to balance inflationary pressures against the risk of stifling economic activity. The concern is that while monetary tightening may be reining in inflation, it could also inadvertently tip the economy into recession.

- Secondly, even as inflation nears its target, interest rates are likely to remain elevated, affecting both consumer and business borrowing. While consumers with fixed-rate mortgages might be partially shielded, the same cannot be said for businesses. Nearly 20% of UK-listed companies have already issued profit warnings in the last year, according to EY-Parthenon. Moreover, a slump in manufacturing orders last month signals increasing economic fragility.

An additional subplot involves the labour market. Wage growth, which surged by over 7% in the three months leading up to May, remains a concern for the BoE. Historical data suggests that inflation is truly tamed only when the job market loosens and vacancy rates fall to normalised levels which is around 2.5% from the current 3%.

Achieving this might necessitate even higher interest rates, potentially up to 5.5%, which would have to be maintained for an extended period!

However, some economic observers are raising red flags that the BoE might be myopic in its approach. The Institute of Economic Affairs and the Institute for Public Policy Research both advocate for a pause, arguing that the impact of prior rate hikes hasn't fully materialised. I think the BoE is being overzealous, potentially overshooting the ideal interest rate by more than a percentage point.

The BoE's own projections indicate that further rate hikes may have a negligible impact on medium-term inflation rates. In my opinion, the toughest, but most sensible action, could be to maintain the status quo. Despite these cautionary tales, the BoE remains resolute in its commitment to a tightening pathway, prepared to hike rates further if inflation remains stubborn.

"Though the peak interest rate may be in sight, inflation should ease to 3.6% by next May!"

On the brighter side, the UK economy has shown resilience so far, managing 0.2% growth in the second quarter. This is modest, but still exceeds expectations which stave off a recession.

The overall economic cost of taming inflation may turn out to be less devastating than initially feared.

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