Government policy, not the Bank of England will determine future interest rate hikes
Today’s inflation data does not address two troubling risk on the horizons: a renewed surge in global energy prices and the upcoming Budget, says William Nixon
This morning’s inflation data came in close to market expectations, with headline inflation rising to 3.1 per cent in August from 2.9 per cent in July. Compositionally, the increase was driven by higher motor fuel prices, with core inflation remaining stable at 2.6 per cent.
Combined with the soft labour market data released on Tuesday, which showed an ongoing contraction in monthly payrolls, the Bank of England is unlikely to hike rates tomorrow.
But it’s far too soon for mortgage holders to breathe a sigh of relief. Even if rates remain unchanged tomorrow, governor Bailey is likely to signal a low bar for rate hikes at upcoming meetings, including as soon as November.
The pivot will reflect two troubling risks on the horizon not captured in today’s data: a renewed surge in global energy prices and the upcoming Budget.
On the first risk, global energy prices have surged higher over recent weeks alongside renewed tensions in the Middle East. Separate to ongoing disruptions in the Strait of Hormuz, the Iran-aligned Houthi group’s recent expansion along Yemen’s west coast has raised concerns about Saudi Arabia’s ability to reroute oil exports through the Red Sea. Key pipeline infrastructure that links Saudi Arabia’s oil fields to export terminals in the Red Sea was also damaged in a drone attack.
The disruptions have seen global oil prices rise around 20 per cent since the end of August, with the Brent benchmark trading above $100 a barrel for the first time since May. Natural gas prices have also risen sharply, with wholesale gas prices in the UK doubling since July and rising above £2 per therm for the first time since 2022.
And as we saw in 2022, higher global gas prices don’t just increase the cost of gas-fired central heating in UK homes. They also increase the price of wholesale electricity in the UK given the grid’s reliance on gas-fired power plants to balance supply and demand.
While it is difficult to give an exact estimate, a sustained increase in global gas and oil prices could see UK households’ combined energy bills rise by 20 per cent to 25 per cent in early 2027 once default tariffs reset. This would directly add around 1ppt to headline inflation and keep overall inflation above 3 per cent through 2027 – well above the Bank’s most recent forecast of around 2 per cent.
Higher gas and electricity prices will also push up businesses’ costs and – as we saw in 2022 – could lead to ‘second round effects’ on inflation as firms increase their retail prices to maintain profit margins. These ‘second round effects’ may be more muted now relative to 2022 given that the weaker real economy makes it harder for firms to pass on costs. But like several peer central banks over recent weeks, including the European Central Bank and the Reserve Bank of New Zealand, the Bank may take a pre-emptive approach to tightening rather than waiting to see if these risks materialise.
Fiscal risk
The second key risk relates to domestic fiscal policy. The Chancellor will deliver his first Budget on 28 October, a week ahead of the Bank’s November meeting, and the market is intensely focused on how the government will respond to the deteriorating economic outlook.
If the government chooses to expand deficit spending to support households, without any attempt to implement structural reforms to tax and welfare settings in the UK, ‘second round effects’ on inflation could be more likely as businesses find it easier to pass on higher costs to households. This would significantly increase the pressure on the Bank to raise rates.
That said, if the government delivers major reforms that reduce the deficit and expand the supply-side of the economy, the Bank could be more willing to ‘look through’ higher energy inflation and keep rates on hold.
As outlined by Policy Exchange’s recent reports on tax and welfare settings in the UK, one bold move would be to reform the ‘triple lock’ on pensions, which ensures pensions rise each year by the highest of inflation, wage growth or 2.5 per cent. While the triple lock shields pensioners from energy-driven price rises, it simply shifts the burden of adjustment to the Treasury and younger taxpayers.
Combined with reforms to non-pension welfare payments and income tax, Policy Exchange estimates the government could simultaneously reduce the deficit and boost the supply-side of the economy by abolishing the ‘Manhattan Skyline’ of marginal tax rates faced by higher earners.
The government could also boost tax revenues and the supply-side of the economy by lifting the moratorium on new drilling for gas and oil in the UK. While new production in the UK won’t fully compensate for disruptions to global energy supplies, the government could follow the example of many medium-sized open economies, such as Australia, by partially recycling tax revenues from these projects to help limit the rise in energy bills faced by domestic households and businesses.
The government could also look to sign up to emerging international financial institutions, such as the Defence, Security and Resilience Bank (DSRB), to help secure defence supply chains and capacity without adding to the deficit.
Ultimately these are choices for the government rather than the Bank of England. But they will be a key driver of how domestic interest rates respond to the global shocks going forward – as well as whether the Prime Minister’s honeymoon extends beyond the end of the year.
William Nixon is a Senior Research Fellow at Policy Exchange and a former economist at Goldman Sachs, the Reserve Bank of Australia, and the Australian Treasury