The coming days will be critical for Britain’s economic fortunes
The latest jobs, retail sales and inflation figures are due – putting the focus on what interest rates will do
This is going to be one of those weeks when the economic data could change our outlook on the economy, especially on interest rates. Tomorrow, we get data on employment and unemployment as well as the latest measure of the growth of average earnings. I am not expecting any blockbusters from either of these but you never know. Any fallback in the rate of increase of average earnings from the latest figures of 5.6pc including bonuses and 6.1pc excluding bonuses would be welcome. On Friday, we get the latest retail sales figures which will be a guide to how things are going on the high street. The really important number, however, is the inflation data, due on Wednesday. To remind you of the story so far, inflation has recently fallen sharply to 3.4pc in February, down from 4pc in January. There is a good chance this week’s March figure will see a further drop to about 3pc.
This would be encouraging because the factors that may bring a really large reduction in the inflation rate still lie ahead. April’s figure (published in May) should benefit from the falling out of last April’s bumper increases across the board as well as the cut in the Ofgem energy price cap.
If this week’s figure is as low as 3pc, then next month’s number could be as low as 1.7pc, in other words, below the 2pc target. What’s more, subsequent months should see further drops, taking the inflation rate down to about 1pc, or possibly even just below.
In normal circumstances, such sharp drops should get the financial markets excited about the prospect of early and substantial reductions in interest rates. But last week we experienced a shock from across the Atlantic. In March, the US CPI registered its third successive 0.4pc monthly increase and the headline annual inflation rate rebounded from 3.2pc to 3.5pc, with the core rate stuck at 3.8pc. Markets reacted by ruling out the prospect of cuts in American interest rates before September.
These disappointing American inflation numbers are particularly significant because over the past couple of years the UK has tended to follow the US inflation experience quite closely – albeit with a lag of about six months. In fact, six months ago American inflation was falling quite sharply so the recent setback shouldn’t pose any worries about the immediate outlook for inflation over here.
It is rather down the track that it might spell dangers ahead. After all, average earnings growth in the UK remains too high to be consistent with 2pc inflation and there was recently a substantial increase in the Minimum Wage, which may reverberate across the lower reaches of the wage distribution. So, as higher labour costs feed through, there is a danger that UK inflation could get stuck above the 2pc target – or even bounce back up from a lower level. For all that, there are good reasons to believe that we can diverge from the US with regard to inflation.
Most important is the difference in the GDP growth rate. Since the start of 2023, quarterly GDP growth in the US has averaged +0.8pc, compared to -0.1pc in the UK. In keeping with this, the UK labour market is loosening whereas in the US the labour market remains very tight. In fact, timely measures suggest that UK inflation is already lower than its American equivalent. The three-month annualised rate of CPI inflation here is already down to 2.9pc, compared with 4.5pc in the US. Furthermore, the UK looks set to benefit more from the falls in energy and food price inflation. This is all very well, you might think, but surely the Bank of England would not be able to cut interest rates if the US Federal Reserve is sitting on its hands. Yet the record shows that it can.
Admittedly, US and UK rates tend to move broadly in tandem but this is not because the Bank of England is timidly playing follow my leader. Our economies tend to move broadly in step and, hence, it is not surprising that the interest rate cycle is closely aligned. Central bankers in the two countries are responding to, and anticipating, broadly similar data.
Yet, when economic circumstances diverge, then interest rate patterns can diverge also. There have been many occasions when the Bank has changed interest rates before the Fed. The latest was in December 2021 when the Bank started to increase rates three months before the Fed. And there have been many occasions when the size of interest rate changes has been different between the two countries.
But won’t the Bank of England be worried about the impact of rate cuts here on sterling? The currency has already weakened in reaction to last week’s news and it could conceivably weaken further if the conviction strengthens that the Bank will cut rates further and faster than the Fed.
Yet this need not be an inhibiting factor. Inflation holds the key. If the inflation rate falls very sharply and looks likely to stay down, then the Bank will surely judge that we can afford a little inflationary pressure emanating from a slightly weaker pound. What’s more, any currency weakness is likely to be restricted to the rate against the dollar. Last week’s meeting of the ECB suggested that eurozone interest rates will probably be cut before very long and that they will probably be about 1pc lower by year end. In keeping with this, last week’s drop of the pound against the dollar was not mirrored by any weakness against the euro.
The upshot is that there is a fair prospect that UK rates will be cut by 0.25pc to 5pc in June and will reach about 4pc by the end of the year and about 3pc by the middle of next year.