The recent announcement that the so-called “Freedom Day” (when remaining covid restrictions will be lifted) is to be put back to 19th July from 21stJune serves as a reminder that the pandemic remains a key risk factor to the economic outlook for the UK. Nevertheless, with the UK economy bouncing back more strongly than had generally been expected and inflation pressures rising, investors are starting to ask when the Bank of England (BoE) will raise interest rates from the emergency levels put in place during the height of the pandemic.
There is little doubt that the plunge in economic activity prompted by the pandemic warranted a dramatic response from policymakers. In March 2020, the Bank cut its official policy interest rate to a record low of 0.1% and restarted its quantitative easing (QE or buying bonds) programme1. The historic nature of the policy response was to prove proportionate to the downturn in the economy; the UK suffered the sharpest economic contraction in 300 years in 2020, with GDP falling a whopping 9.8%2.
However, the UK’s successful vaccine rollout and subsequent economic reopening has dramatically improved prospects in 2021. Lately, forecasters have been falling over themselves to revise up projections for the UK economy. In May, the Bank of England upgraded its 2021 GDP growth forecast to 7.25% from the 5% it expected back in February3. Similar upward revisions have been seen from international bodies such as the OECD.4
Upbeat economic projections have been supported by incoming data that has generally been stronger than expected. GDP rose 2.3% m/m in April, as children went back to school, the hospitality sector partially reopened and non-essential retailers welcomed customers back to their stores5.
Although the delay to a full reopening of the economy will hit the hospitality sector and dampen near-term activity, it is unlikely to derail the recovery. Helped by a booming housing market, consumer confidence has bounced back, raising the prospect that the savings accumulated during the pandemic will be spent during the coming months and years6. Andy Haldane, the outgoing Chief Economist at the Bank of England, estimates that households have accumulated around £200bn of excess savings (around 15% of annual consumption spending) while companies have accumulated around £100bn (about half of annual investment spending)7.
Against this backdrop, it is no surprise that demand is picking up, with the latest Markit PMI report for May showing manufacturing orders rising at their fastest pace in the survey’s near three-decade history, while the services sector reported the strongest growth in activity in 24 years.
Nevertheless, reports of supply bottlenecks and labour shortages have raised concerns as to whether companies can accommodate the surge in demand without raising prices. The pandemic has disrupted international supply chains for goods ranging from computer chips to timber. In addition, shipping costs have risen to historic highs10. With backlogs building and delivery times rising, manufacturers have reported a sharp jump in purchasing costs which is leading to the steepest hike in output prices in at least 30 years according to the Markit UK PMI survey11.
Difficulties in recruiting workers are also putting upward pressure on wages despite the fact that the official unemployment rate of 4.7% is still nearly one percentage point higher than pre-pandemic levels and the prevailing level of GDP is still around 4% lower12,13. The latest KPMG/REC report for May reported deteriorating staff availability and showed starting salaries for permanent staff rising at their fastest pace since September 2018.14
All of this suggests that inflation pressures are building in the UK economy. It is well known that comparisons with pandemic-hit prices of spring 2020 (so-called ‘base effects’) will cause headline inflation to rise during the coming months. Indeed, forecasts from the Bank of England anticipate that higher energy prices and the expiry of the temporary VAT cut for the hospitality sector will help lift inflation to around 2.5% during the last quarter of 2021, up from the 1.5% recorded in April15.
UK more inflation prone?
There are good reasons why many of the factors that are currently pushing up prices will prove transitory, and a return to 1970s-style inflation looks unlikely (see our commentary of April 2021). However, circumstances unique to the UK might leave the economy more vulnerable to persistent inflation and an earlier tightening in monetary policy compared with other developed economies.
A key factor in this regard is labour supply and the related issue of workers’ bargaining power. Reports of labour shortages have been commonplace in parts of Europe and the US16,17, with fear of coronavirus and emergency transfer payments cited as factors which have disincentivised some workers from returning to the labour force. As vaccines are more widely distributed and enhanced benefits/furlough schemes come to an end, these constraints on labour supply can be expected to diminish.
However, pandemic-related issues aside, the UK’s departure from the EU earlier this year adds an additional complicating factor regarding labour supply. Estimates suggest that over one million immigrant workers left the UK during the pandemic 18, and the government’s new immigration regime will now act as a barrier for low-paid workers to enter the UK. The prospect of reduced labour supply growth is one reason, along with weak productivity, why the Bank of England now estimates the UK economy’s potential growth rate – i.e., the rate at which it can grow without sparking higher inflation – at just 1.1%19. This suggests that underlying inflationary pressures could build quite quickly as pent-up demand is released and economic activity bounces back to pre-covid levels.
Indeed, another factor which might incline the Bank of England to withdraw stimulus earlier than the US Federal Reserve and the European Central Bank is that the UK has not had a persistent problem with inflation undershooting its 2% inflation target. The US Federal Reserve has indicated that it will not hike rates until inflation is on track to moderately exceed 2% for some time, in order to make up for an earlier period of below-target inflation (see our commentary of September 2020). By contrast, inflation in the UK has averaged around 2.1% since 200920.
A rate hike in 2022?
Taking all these factors into consideration, it is perhaps not surprising that the Bank of England is turning more hawkish and we are starting to see tentative evidence of a dialling back in monetary stimulus. In May, the BoE announced that it would keep its total target stock of asset purchases at £895 billion (the BoE’s QE programme is not open-ended like that of the US Federal Reserve), but it would slow the weekly pace of its bond buying from £4.4 billion to £3.4 billion21. A further assessment is expected in August, with the Bank on course to stop purchases altogether by the end of 2021.
It is reasonable to expect that, barring any nasty surprises, the completion of the Bank’s QE programme this year will pave the way for a hike in interest rates during the second half of 2022. By this stage, the post-covid recovery should be well advanced, slack in the economy should be much reduced, and underlying pressures in both inflation and wages should be apparent. The financial markets are gradually moving towards anticipating higher interest rates – a hike in Bank Rate to 0.5% by the end of 2023 is currently priced in22- but arguably do not reflect the upside growth and inflation risks the economy faces. Against this backdrop, the UK government bond market – where the yield on the 10-year Gilt stands at just 0.74% - holds little appeal for UK investors requiring inflation-beating returns.23
15th June 2021