If No10 is banking on a sustained fall in interest rates, it must think again
As long as the Fed keeps borrowing rates elevated, it is hard for the Bank of England to break ranks
‘You put your right foot in, you take your right foot out. You do the hokey cokey and you turn around: that’s what it’s all about.” Interest rate expectations, which seem to change with breathtaking regularity these days, are perfectly summarised by this catchy little ditty.
At the turn of the year, all was apparently set for a steep fall in official policy rates as the post-pandemic surge in inflation gave way to more settled conditions and price stability progressively re-established itself.
Yet just as borrowers had started to believe in a significant cut to mortgage rates later this year, all bets are off again.
This is not just a UK phenomenon. Far from it. Developments elsewhere, and particularly the US, are the primary driver of last week’s abrupt recalibration of interest rate expectations.
Three disappointing US inflation reports in a row, the last of them on Wednesday, have dramatically altered perceptions. US growth is on a tear, and inflation is proving stickier than anticipated, causing markets to halve the number of interest rate cuts the Federal Reserve is expected to make this year.
It’s the same for the eurozone and the UK, even though growth this side of the pond remains subdued, and inflation seems for now to be somewhat better behaved.
What’s happening in the US, it seems, is as important in determining the expected path of interest rates in the UK as what happens back home.
This has perhaps been the case for some time now. As long as the Fed keeps interest rates elevated, it’s very hard for the Bank of England to act unilaterally to bring them down.
To do so risks a flight of capital to the higher interest rate environment of the US, which in turn would weaken the pound and cause inflation to rise anew.
All this is very unwelcome news for the beleaguered inhabitants of Downing Street. Rishi Sunak, the Prime Minister, is banking on the economy to deliver what little hope remains of surviving the next election.
In a recent Conservative Party pamphlet, MPs – existing and prospective – are told to emphasise the economy above all else. “We are making real progress – and it is clear the economy is beginning to turn a corner”, the pamphlet insists.
It’s true that last year’s technical recession now seems to be over, with some degree of growth – albeit marginal – now pretty much baked in for the first quarter.
Yet the Government also wanted to see interest rates on a sustained downward trajectory before going to the polls. This may now be denied. Ministers seem thwarted at every turn. Already starved by the Office for Budget Responsibility of the fiscal means to juice the voters before the election, markets now seem minded to deny them easier money as well.
It has become fashionable to argue that the Bank of England is making the same, behind-the-curve mistakes coming out of the inflationary surge, with rates held too high for too long, as it did going into it, when it kept rates too low for too long.
Maybe so. A Bank of England commissioned review by Ben Bernanke, a former chairman of the US Federal Reserve, has found the Bank’s forecasts and modelling to have “significant shortcomings”.
Thanks so much; we hardly needed a Nobel laureate to tell us that. Even as late as September 2021, when inflation swept through the level that obliges the Governor of the Bank of England to write to the Chancellor explaining why, it was already plain to anyone with any sense that the inflationary genie was out of the bottle. Yet the Governor sought only to explain why he wouldn’t be doing anything about it.
The inflationary pressures were “transitory” in nature, he insisted, and he hesitated to take any action that might derail the post-Covid recovery.
The forecasting models told him that inflation would peak at little more than 4pc, before subsiding back to target in the medium term. Water under the bridge now, it might be thought. But if central banks were making mistakes like these back then, it’s reasonable to assume that they are continuing to make them now that things are a little calmer.
“Give growth a chance,” shout the Bank of England’s critics. Yet as long as the Federal Reserve has its foot on the brakes, there’s a limit to how far the Bank of England can diverge.
What’s more, unlike the Government, I remain to be convinced that the inflationary dragon has indeed been slain. In an intriguing intervention last week, Megan Greene, a relative newcomer to the Bank’s Monetary Policy Committee, pointed out that objectively speaking, the UK continues to seem somewhat more vulnerable to inflation than the US, even though Britain has much slower growth.
Her argument was that although the risk of persistent inflation had diminished, potential supply in the UK economy is a good deal more restricted than in the US, meaning that the UK has less scope than the US to grow without triggering inflation. Markets were therefore wrong in betting that interest rates would fall more quickly here in the UK than the US. Possibly so, but the bigger picture is that we appear joined at the hip to relatively high US rates even though we have much lower growth.
In a version of “when America sneezes, the rest of the world catches a cold”, interest rate expectations across the globe are once more taking their cue from the US, with rates now slated to remain higher for longer almost everywhere. Nor should this really surprise. The fall in UK inflation back to target is largely owing to the base effects of deflating energy prices. There are now signs of these reversing, with renewed instability in the Middle East.
Furthermore, lots of prices are still rising, from council tax and water to broadband bills and mobile phone charges. Service inflation and wage growth are still, moreover, running at levels that are incompatible with a 2pc inflation target.
It was not part of Bernanke’s brief to apportion blame for the inflationary debacle of recent years, only to identify faults in the Bank of England’s procedures and messaging, and to recommend reforms.
It is also true, as Bernanke points out, that any deficiencies were characteristic of central banks as a whole, not just the Bank of England.
Even so, it’s going to take more than a few changes in messaging and modelling to lance the boil of perceived failure. For that you need trial and retribution.
Winning back credibility will take a long time, which is one of the reasons why the Bank hesitates before chopping interest rates anew, for fear of acting prematurely.
But even if the Bank wanted to, is it actually possible to act unilaterally in today’s globalised capital markets?
We like to pretend Britain still has full monetary sovereignty, but as on so much else we are in practice largely prisoners of whatever the US decides to do.
‘I remain to be convinced that the inflationary dragon has indeed been slain’