Introduction to Interest Rates
The Bank of England’s ability to lower interest rates may be limited due to strong UK pay growth and potential rate cuts in the US. Megan Greene, a member of the Bank’s monetary policy committee, expressed concerns that wages are growing strongly again, which could prevent inflation from easing.
Wage Growth and Inflation
Recent Bank of England surveys suggest employers are planning to give pay rises of 3.5% or more this year. The latest official figures show wage growth, excluding bonuses, weakened slightly to 4.5% between September and November, from 4.6% in the previous three months. The MPC has a target for inflation of 2%, but figures released this week showed it reached 3.4% in December, up from 3.2% in November.
Impact of Wage Growth on Inflation
Consistent wage growth tends to push up inflation if there is not a corresponding rise in productivity growth. Greene said she was "certainly sceptical" that productivity would rebound this year. The MPC’s decision on when to lower borrowing costs will also be affected by whether the US Federal Reserve lowers rates, as this could cause inflation in the UK to rise.
US Federal Reserve’s Influence
"If the Fed were to cut rates more aggressively than the Bank this year, this should cause US demand for UK exports to rebound, providing upward pressure on UK inflation," Greene said. This highlights the complex relationship between interest rates, inflation, and global economic factors.
Bank of England’s Forecasting Challenges
A separate report from the Bank concluded that it had consistently underestimated the full effects of inflation that came after the energy price shock of 2022. The Bank’s models had not anticipated the extent to which higher inflation in 2022 led to households and businesses having higher inflation expectations, leading them to push for higher wages, which in turn added to further inflation pressure.
Improving Forecasting Models
The Bank said it would try to improve its "modelling and understanding of key economic mechanisms, including the labour market, wage-price interactions and inflation expectations" to better understand the recent "inflation persistence". This effort aims to enhance the accuracy of future forecasts and inform more effective monetary policy decisions.
Business Activity and Inflation
A survey of activity among UK businesses showed that companies were reporting a sharp rise in costs in January, with the overall pace of inflation unchanged from December’s seven-month high. The purchasing managers’ index from S&P Global showed businesses in manufacturing and services sectors were "overwhelmingly" linking rising costs to "elevated wage pressures", alongside rising transport bills and raw material prices from suppliers.
Job Market Trends
The survey also showed a "steep loss" of jobs among many of its respondents, especially in the hospitality sector. Many companies attributed the job cuts to the government’s introduction of higher national insurance contributions and increases to the "national living wage".
Conclusion
The Bank of England’s ability to lower interest rates is uncertain due to strong UK pay growth and potential US rate cuts. The complex interplay between inflation, wage growth, and global economic factors will continue to influence the Bank’s monetary policy decisions. As the UK economy navigates these challenges, it is essential to closely monitor developments and adjust policies accordingly to achieve the target inflation rate of 2%.
