Gianluca Benigno: The UK Inflation Rate and the Bank of England’s Decision
Gianluca Benigno is a distinguished professor of economics at HEC Lausanne and formerly led international research at the NY Fed.
After two consecutive months of the UK inflation rate hitting the Bank of England’s 2 percent target, the central bank has finally decided to cut rates today, marking its first rate cut since the onset of the Covid-19 pandemic.
According to the Monetary Policy Committee’s statement:
It is now appropriate to reduce slightly the degree of policy restrictiveness. The impact from past external shocks has abated, and there has been some progress in moderating risks of persistence in inflation. Although GDP has been stronger than expected, the restrictive stance of monetary policy continues to weigh on activity in the real economy, leading to a looser labor market and bearing down on inflationary pressures.
Despite the current inflation rate being lower than the interest rates at 5 percent, the Bank’s delayed decision to cut rates raises questions about its timing and effectiveness.
One key concern for the Monetary Policy Committee is the persistent services inflation in the UK, which remains high while goods inflation has slowed down significantly.
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Notably, the MPC’s decision to maintain the policy rate at 5.25 percent was influenced by the persistent services inflation and strong GDP growth, indicating concerns about enduring structural shifts and inflationary pressures.
One of the reasons for the prolonged services inflation could be the impact of monetary policy on housing rents, a significant component of services inflation. As interest rates rise, mortgage rates increase, leading landlords to raise rents and perpetuate the inflationary cycle.
The UK rental market’s unique characteristics, coupled with the sensitivity of mortgage rates to policy changes, contribute to the transmission of monetary policy effects on rental costs.
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The rise in mortgage rates has a direct impact on housing rents, contributing to the persistent services inflation in the UK. This interplay between interest rates, mortgage costs, and rental prices highlights the complexities of the inflationary environment.
As the Bank of England acknowledges, the adjustment of rental prices to interest rate changes may take time, prolonging the impact of higher rates on services inflation. The reluctance to cut rates sooner may have inadvertently contributed to the persistence of services inflation.
Given these dynamics and the need to address inflationary pressures, the Bank of England’s decision to cut rates should mark the beginning of a sustained easing cycle to support economic recovery.
Further reading:
– So long, and thanks for all the fixed-rate mortgages? (FTAV)
– Britain, land of the eternal mortgage (FTAV)
– Andrew Bailey vs the renters? (FTAV)