• UK inflation has been stoked by a double whammy of drivers – a US-style labour supply squeeze and a euro area-style energy and food price shock, contributing to stickier-than-expected inflation.
• One major transmission mechanism of UK monetary policy is through the housing market. The evidence suggests this channel is less effective than in the past and will have longer lags. But monetary tightening is already, albeit gradually, squeezing real incomes.
  
• We think the market’s expectation for interest rates to peak at 6% is slightly excessive. Real incomes are set to drop sharply and will eventually trigger recession. We now expect the Bank Rate to peak at 5.5-5.75% and for it to stay there until at least mid-2024. 
  

The UK has a sticky inflation problem. The Bank of England (BoE) was the first major central bank to start hiking rates, in December 2021. But despite this first-mover advantage it has had less success in taming price pressures than its European or American counterparts.

Core inflation (excluding energy and food prices) has accelerated to above 7%, with a tight labour market and strong private-sector wage growth adding to concerns. This contrasts with the US and euro area experience, where the disinflationary process appears well under way and core inflation seems to have peaked.

Figure 1: UK core inflationary pressures have diverged with the US and eurozone

Source: ONS, Eurostat, BLS, Bloomberg. As at 22 June 2023. 

Note: CPI refers to consumer price index.

Financial markets agree with this view. Two-year UK government bond (‘gilt’) yields are trading above 5%, exceeding the level reached during the UK’s ‘mini-budget’ crisis last autumn mortgage rates have soared and markets are now pricing in a peak bank rate of 6%, which is 75 basis points (bps) higher than peak expectations for the US Fed Funds Rate.

The question is, why is the UK’s situation different to that of the US and Europe? And are markets correct to think that the BoE will need to push rates to as high as 6% to tame inflation?

In our view, one of the reasons behind the divergence is that the UK has suffered from the worst of both worlds in terms of inflation drivers – a US-style labour supply shock and a eurozone-style energy and food price shock. Further, UK monetary policy has been less effective and is taking longer to feed through to the economy than in the past. But with 490 bps of rate hikes already baked in the cake, there is more pain to come, especially for mortgage-holders.

The worst of both worlds

The chart below illustrates how UK inflation has evolved in recent years, decomposed into its four main components: energy, food, core goods and core services. The inflation surge started in 2021, driven by the easing of Covid-19 lockdown restrictions. Imbalances in global supply chains¹ and a shortage of labour in specific industries² led to an acceleration in both core goods³ and services prices.

Figure 2: UK inflation can be explained almost equally by its four main components

Source: ONS, Bloomberg, Vanguard. As at 22 June 2023. 

Note: CPI refers to consumer price index.

Although disruptions to global supply chains have now largely reversed⁴, the supply of UK labour remains restricted. For example, the inactivity rate, which measures the portion of working age people that are not in the labour force, jumped 1.5 percentage points between February 2020 and July 2022, driven by a rise in long-term sickness, as well as increased numbers of people opting to study or retire⁵. The inactivity rate has fallen back in recent months but remains around a percentage point above its pre-Covid level. This lower supply of labour is contributing to the tight labour market and high wage growth we are witnessing today.

But this was not the only blow. In early 2022, when UK consumer price inflation (CPI) inflation was already above 6%, the UK was hit by a large energy and food price shock as Russia invaded Ukraine.

Surprisingly, the energy shock was larger in the UK than in the euro area. Governments on the continent capped prices sooner and at a lower level than in the UK; and the latter’s regulatory price mechanism (the Ofgem price cap) means prices are slower to fall back too. This pushed UK inflation to a peak above 10%, higher than any other major advanced economy, though the headline rate appears to have peaked now.

Today, there is roughly an equal (and large) contribution to UK inflation from all four major components, as the chart above shows. This is unique. In the US, core services dominate, whilst in the euro area energy prices did most of the work of driving inflation before being replaced by food. The UK has the worst of both worlds, suffering from a US-style labour supply shock as well as a euro area-style energy & food shock. High and sticky inflation is the result.

A slow-motion mortgage squeeze

At face value, it is surprising that core inflation is so high given that the BoE has already delivered almost 500 bps of rate hikes over the last 18 months. But part of the story may be that the effect of tighter monetary policy on the housing market⁵ is slower and less impactful than in the past.

The portion of outstanding mortgages that are on variable rates has fallen from around 50% in 2016 to less than 20% as at the end of 2022⁶. Similarly, the popularity of longer fixed-rate deals (five years and over) has increased at the expense of shorter alternatives (such as two-year deals).

This has had the effect of slowing down the transmission of monetary policy to the real economy as more households are now able to wait longer before re-financing their mortgages. Consequently, the BoE believes the peak impact of higher mortgage rates on the economy will not happen until 2025⁷. A lot of pain is already baked in the cake, it’s just taking time.

The mortgage channel is also less potent than before as a greater proportion of homeowners now own their home outright, so they are not impacted by higher mortgage rates. Indeed, in sharp contrast to 25-30 years ago, there are now more outright homeowners than mortgagers in the UK, as the chart below shows.

Figure 3: The proportion of homeowners with a mortgage has fallen significantly in recent decades

Source: UK Housing Survey, annual data from 1997 to 2021.

Market reaction slightly overdone

At the time of writing, on the back of higher inflation driving higher UK rate expectations, markets are pricing in the Bank Rate to peak at 6%, more than one percentage point higher than it was just a month ago.

Although we agree that inflationary pressures are proving stickier than anticipated, we think the initial market reaction is a bit of an overreaction. By the end of 2024, more than three million households are likely to have re-financed their mortgages at rates above 3.5%. Real incomes will slowly be squeezed - and the bank knows it.

Meanwhile, there are tentative signs that the tightness in the labour market is easing. Job vacancies, although elevated, have now fallen for twelve consecutive months, and job-to-job flows are softening. A recovery in labour force participation is also encouraging.

All in all, we’ve upgraded our peak rate expectation for the UK, but we haven’t gone as far as the market is pricing in. We now expect the UK interest rate to peak at either 5.5% or 5.75% (previously 4.75% or 5%), and don’t expect rate cuts until the second half of 2024 at the earliest.

¹ The UK is a relatively open economy with the value of its annual imports and exports standing at around 60% of GDP. This is about seven percentage points above the average across major economies.

² See, for example, this research briefing conducted by the UK Parliament using ONS data.

³ Core goods prices were also pushed up by a weakening exchange rate. During 2022, sterling depreciated around 10% against the US dollar and 5% against a basket of currencies that reflect its major trading partners. 

⁴ As per the PMI survey, UK manufacturing supplier delivery times are now close to pre-covid levels. 

⁵ Average mortgage payments in the UK typically account for 25-30% of annual household income. 

⁶ Source: Bank of England May Monetary Policy Report, data from January 2004 to March 2023.

⁷ See Bank of England’s May Monetary Policy Report, page 65.