Who's in charge of UK inflation?

May 21, 2024

Conventional wisdom is that higher official interest rates will intentionally slow the consumer economy, leading to lower economic activity and inflation. Broadly, the theory here is that higher rates mean that consumer debt costs more to service; consumers consequently have less disposable cash, so consumption slows, leading to lower economic activity and lower inflation. The Bank of England's Monetary Policy Committee then congratulates itself for doing its job and delivering lower inflation (should it have been chastised for presiding over higher inflation?), and off we all go, confident in the ability of the UK monetary authority's ability to manage future price stability.

Most economic commentators and, indeed, policymakers would have us believe that this is pretty much what has happened since February 2022 when Russia invaded Ukraine. UK inflation consequently leapt from about 2% to 11% and then, following considerable policy tightening, fell back to 2% again.

However, could there be an alternative explanation, one that reveals the impotence of higher rates to slow the economy and attributes the rise and subsequent fall in inflation to factors that have nothing to do with the actions of the MPC?

Let's start with recent history. Following Russia's invasion of Ukraine in February 2022, this is what happened to UK inflation. Its rapid rise had nothing to do with any domestic UK economic issue and was entirely the product of factors beyond the control of the UK monetary authority.

Chart showing energy prices and CPI inflation. CPI inflation peaks at 11% in 2021 and is now at 2%. Energy inflation peaked at 50% and is now at -15%.

As you can see, energy inflation has fallen as fast as it rose and, apparently in lockstep, so has UK inflation as measured by the CPI.

Has this fall in inflation been the product of the MPC's interest rate increases, or would it have happened regardless of policy tightening? Even asking this question will have many of you wondering if I have lost my mind. Surely it is self-evident that higher interest rates will slow the economy and reduce inflation by taking money out of consumers' pockets to service the higher cost of debt?

Well, no, actually. The reality is that higher interest rates have, in aggregate, put considerably more money in UK consumers' pockets, not less, as you can see in the chart below.

Chart showing change in household interest income since December 2021. Household deposit income is at £38 billion. Mortgage payments are at £18 billion.

To remind you, this is a product of two things I have mentioned in previous articles:

  1. Total UK household deposits are approaching £300bn bigger than total household loans.
  2. 86% of mortgages are fixed rate, and most are 5-year fixes (only just under a third of the 29 million households in the UK have a mortgage). This means that the rates people pay on their mortgages only slowly change in response to changes in official interest rates.

Just in case you think I have gone mad, let's look at another aspect of the consumer economy in 2024. This year, approximately 1.6 million people with a mortgage will be refinancing. The average mortgage is £150,000, and those customers refinancing will typically be going from a rate of 2% to about 4.5%. This will increase monthly payments for these households by around £200 per month, or close to £2,500 a year. In aggregate, that will take £3.5 billion out of their pockets. 

However, in 2024, all 29 million households in the UK will be paying less for gas and electricity. In total, this energy saving will amount to £15 billion, over four times the size of the higher mortgage bill.

Diagram showing aggregate household cashflow being more affected by reduced energy bills than increasing mortgage payments

In other words, higher UK rates will not only increase consumer cash flow in aggregate, but the headwinds they cause for those refinancing in 2024 will be massively outweighed by the benefit of lower domestic energy bills for all households.

My conclusion, therefore, is that the MPC's policy tightening steps, which have been carefully calibrated by the committee and which were designed to deliver the appropriate monetary policy medicine to the UK economy to deliver inflation back to target, have, if anything, delivered economic stimulus to the UK consumer economy by boosting aggregate consumer cash flow. The uncomfortable reality is that UK inflation rose and then fell for reasons that had nothing to do with the domestic economy or official interest rates. The economy struggled last year mainly because higher energy prices and inflation acted like a tax on UK consumers. This year, the energy price "tax cut" will boost consumer cash flow, which, when combined with strong real income growth, will deliver much better growth to the overall economy.

This is quite hard to take on board. Effectively, I am saying that monetary policy no longer works as it used to in the UK. The UK consumer economy's sensitivity to interest rate changes has altered fundamentally, and this might be one of the reasons why the Bank of England's forecasts for the economy have been, and in my opinion, continue to be so wrong. 

So, who can control UK inflation? Conventional thinking would, of course, point to the Bank of England and its core function to deliver price stability, but if I am right, and the evidence seems to support my assertion, that the relationship between base rates and consumer cash flows has fundamentally changed, then this conventional thinking needs to be rethought. Based on what I see, higher rates boost consumer cash flows, not reduce them. Consequently, the MPC's traditional approach to delivering price stability might need, at least, to be re-examined. Maybe this is one of the things Ben Bernanke had in mind when he recommended recently that the Bank of England thoroughly revamp its UK economic model.

Disclaimer: These articles are provided for information purposes only. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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