With UK inflation now nearing the Bank of England’s (BOE) 2% target, many homeowners burdened by the highest mortgage costs in decades are questioning why the central bank hasn’t lowered its key interest rate. The explanation lies in the economic complexities post-COVID-19 and the BOE’s cautious approach to avoid past mistakes.
1. What’s Been Happening to UK Inflation?
In April, UK inflation eased to 2.3%, the lowest since the cost of living crisis began nearly three years ago. Inflation has been on a steady decline since late 2022, as global supply chain disruptions and sharp increases in energy and food prices gradually dissipate. However, the BOE remains cautious about underlying price pressures, particularly in the services sector, which are still high and could cause inflation to rise again in the latter half of the year due to so-called second-round effects.
2. What Are Second-Round Effects?
Second-round effects occur when workers demand higher wages to recover lost income from previous inflation spikes, which in turn drives further price increases. Currently, the UK’s tight labor market strengthens workers’ bargaining power, keeping unemployment low and job vacancies high. This situation results in elevated services price increases and wage growth, both of which the BOE monitors closely as they indicate inflation persistence. Despite headline inflation nearing the BOE’s target, these underlying pressures suggest inflation might not stay low sustainably.
3. What Actions Has the BOE Taken?
The BOE has taken a cautious approach to reversing its aggressive monetary tightening. The benchmark interest rate is at a 16-year high of 5.25%, following 14 consecutive hikes aimed at curbing inflation. The BOE paused its rate hikes in September and has held the policy steady for the past six meetings. In February, the BOE hinted at potential rate cuts later this year, preparing markets for a possible reduction in the summer. Two members of the nine-member Monetary Policy Committee voted for lower rates in May, and Governor Andrew Bailey suggested a potential cut in June. However, the BOE insists that even after one or two quarter-point cuts, policy will remain restrictive to control inflation.
4. What’s the Likely Path of UK Interest Rates in 2024?
In previous rate-cutting cycles—in 1998, 2001, and 2008—the BOE acted during economic downturns to support growth. This time, the focus is on controlling prices during a tentative recovery. Recent data showed the UK emerging from a mild recession with the strongest quarterly growth since the pandemic. The BOE has adopted a “Table Mountain” strategy, keeping rates high and stable to suppress price pressures. The central bank reached this high-rate plateau in September and is now waiting for clear evidence of cooling wage and price pressures before cutting rates.
BOE Chief Economist Huw Pill mentioned that a summer rate cut is possible but acknowledged the need for more work. Policymakers aim to avoid premature cuts that might necessitate a swift return to tighter policies, risking accusations of inconsistency. They also seek to provide a stable environment for businesses and consumers to plan.
5. Why Are UK Homeowners Sensitive to Interest Rate Changes?
Most UK mortgage holders have fixed their rates for just two or five years, unlike in countries where longer-term fixed mortgages are common. Although this is an improvement from the past when most mortgages were on variable rates, many households face significantly higher repayments as their fixed-rate deals end, requiring renegotiation. This situation exacerbates the housing affordability crisis, driven by decades of underinvestment in new homes, and increases pressure on Prime Minister Rishi Sunak’s government to alleviate the burden on home buyers. Mortgage costs surged due to economic mismanagement during Liz Truss’s brief term, and the Conservative Party is eager to restore its credibility to close the polling gap with the Labour opposition.
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