Macroeconomic policy Macroeconomic Policy Outlook: Q3 2023 5 October 2023 Simon Pittaway James Smith Greg Thwaites In this edition of the MPO we focus on the scale and nature of the UK’s inflation challenge, looking at what we can learn from comparisons with other countries, and what that means for monetary policy. A key reason to worry about UK inflation is that it looks exceptional: it is the highest headline inflation in the G7, nearly double the rate in the US. Stripping out the direct effects of energy and food does not change the picture with UK core inflation also the highest in the G7, more than 2 percentage points higher than the US. But this ‘exceptionalism’ in UK inflation is, to a large extent, a reflection of our approach to the energy markets which means we’ve faced a more protracted energy-price shock. That explains much of why UK headline and core inflation performance has been the worse than elsewhere, with core inflation significantly affected by the indirect effects of the price shocks hitting the UK. Headline inflation rates are much closer across the UK, US and euro area once the timing of the fall in energy prices is accounted for. Instead, what stands out for the UK is the strength of nominal wage growth, with private-sector regular pay rising by 8.2 per cent in Q2 2023 – well above the Bank of England’s comfort zone (of around 3.5 per cent). More worryingly, wage growth is around 3 per cent stronger than would be suggested by the current tightness of the labour market, even after taking into account short-term inflation expectations. Indeed, nominal wage growth has been so strong in the UK that headline measures of real wages have risen by a similar amount to those in the US, despite much higher inflation. This points to large ‘second-round’ effects of higher energy prices for the UK. Along with this, there is little sign of the supply-side improvement in the US, with UK productivity growth continuing to flatline. The flipside of all this is that, unlike in the US and euro area, measured profits do not seem to be adding to inflationary pressure in the UK. So the labour market – and particularly prospects for wage growth – are key to where inflation goes next. With the UK labour market already loosening rapidly, and with between a half and two-thirds of the monetary tightening impact still to be felt, the key question now becomes, how long will interest rates remain at current levels, echoing the current US debate about the future of rates. While there is a growing expectation that the UK will follow the US in holding rates at their peak for an extended period (adopting a ‘higher for longer’ strategy) this will depend on the extent to which the labour market continues to loosen. As the rate rises already in train are likely to feed through to the economy more slowly than in the past – given the rise of fixed-rate mortgages – the tightening in train could mean the UK’s stay at over 5 per cent interest rates could be shorter than in the US. UK headline and core inflation are higher than elsewhere, but this largely reflects the indirect impact of higher energy prices UK headline inflation is higher than among other rich countries. As shown in Figure 1, the UK has the highest headline inflation in the G7 at 6.7 per cent in August, nearly double that in the US, which is 3.7 per cent (based on US CPI inflation). More worryingly, even once we exclude the direct effects of energy and food prices (i.e. core inflation, also shown in Figure 1), UK inflation remains the highest in the G7 and more than 2 percentage points above the US. The decisive falls in this measure, evident in the data for the US and euro area, have yet been elusive for the UK. So in this edition of the MPO we dig into why the UK is experiencing higher inflation, comparing our experience to that in the US and euro area, and discuss what the scale and nature of the inflation problem means for macro policy. Figure 1: UK headline and core inflation looks higher than other rich countries This exceptionalism is to a large extent a reflection of how the rise in energy prices feed through to household spending in the UK. As shown in Figure 2, the peak direct impact of energy on headline CPI inflation has been similar in the euro area and UK. And while the impact of energy on inflation started to fall sharply in the US in July last year, and in the euro area in November, for the UK, this was only clear from April this year. This delayed impact reflects the Ofgem price cap which introduces a lag from changes in wholesale-energy prices and household bills. This feeds through into higher headline inflation directly, but there are also indirect effects on prices from the cost of energy as an input to other goods (retail-energy prices are highly correlated with firms’ energy costs). For this reason, core inflation tends to move closely with headline inflation, even during periods marked by large movements in energy prices. Indeed, as shown in the right chart in Figure 2, core inflation has not generally proved to be more persistent than headline inflation, even in the aftermath of energy shocks. For this reason, core inflation receives too much attention and is often mistaken for a gauge of ‘underlying’, or domestically-generated, inflation. Figure 2: The contribution of energy to inflation fell later in the UK than in the US or euro area Instead what really stands out for the UK is the pace of wage growth UK pay growth has accelerated alarmingly in recent months: annual private-sector regular pay growth – the Bank of England’s key metric of inflationary pressure coming from the labour market – increased to 8.2 per cent in Q2 2023 from 7.1 per cent in Q1 (Figure 3). This is well above the 3.5 per cent growth rate that is roughly consistent with the 2 per cent inflation target. More worryingly, higher-frequency measures suggest wage growth has been accelerating in recent months with annualised growth in Q2 2023 of 11.1 per cent, compared with 6.5 per cent in Q1. While there were some signs of pay growth moderating slightly in July, it is still far from the decisive declines seen in the US. And while some of the UK acceleration can be attributed to the 9.7 per cent increase in the National Living Wage, we estimate that this only accounts for around 0.5 percentage points of that acceleration. Figure 3: UK nominal wage growth does look exceptional UK wage growth is much stronger than would be expected, even given the tightness of the labour market. As shown in Figure 4, UK wage growth (adjusted for short-term inflation expectations) is around 3 percentage points above what might be expected given the current tightness of the labour market (as measured by the vacancy-to-unemployment ratio). This suggests stronger underlying inflationary pressures than in the US, where wage growth, if anything, is surprisingly low when viewed in the context of the relationship between tightness and wage growth over the decade preceding the pandemic. For the UK, this is consistent with substantial ‘second-round’ effects of higher energy prices on wages, whereby higher inflation feeds into higher wages, creating lasting upward pressure on prices. But it also means that UK real wages have grown by a similar amount to those in the US, despite stronger inflation and a weaker economic recovery. Figure 4: UK wage growth is much higher than would be expected given the tightness of the labour market There is also little sign in the UK of the strong supply-side performance seen in the US. Because higher productivity effectively pushes down on firms’ costs, breaking the link between increases in wages and rising prices, this supply-side performance plays a key role in how such pay pressures feed through into future inflation. As shown in Figure 5, productivity performance in the US has been relatively strong since the onset of the pandemic, allowing US workers to be paid more without creating extra pressure on unit labour costs. By contrast both the UK (and euro area) have had weak productivity growth, which has added to inflationary pressure. (This is a key reason why productivity performance should remain at the top of the policy agenda even during the cost of living crisis – see our recent report on business investment for some ideas about how to boost productivity growth.) The flipside to this is that the labour market – and particularly prospects for wages – are clearly crucial to where UK inflation goes next. For the UK, falls in productivity growth often come with a fall in measured profits and a bigger share of value added going to workers (the details of why measurement is an issue here is covered in a speech by Jonathan Haskel). This shift has happened again, with the labour share rising since the onset of the pandemic, and in contrast to the US and euro area, has pushed up on inflation. This is consistent with work by the Bank of England and Decision Maker Panel that has found profits are not playing a key role in driving aggregate inflation. Figure 5: Weak productivity will be a key factor pushing up on inflation The UK’s rapidly loosening labour market suggests that the Bank of England may not have to keep rates above 5 per cent for as long as the Fed With the Bank of England seemingly having ended its rate-tightening cycle, the question is now: how long will rates stay above 5 per cent? (Rather than: how high will they go?) To answer that, we need a sense of how much tightening the Bank of England has put in train. Figure 6 shows two ways to assess this. The first, in the left panel, is based on the impact of rate increases on inflation based on the Bank of England’s own historical estimates. These estimates suggest that around half (48 per cent) of the impact of the rate rises on inflation should be visible in the data by June 2023 (the latest quarterly data point for wage inflation). But these estimates cover the period from 1993 to 2007, and so do not take account of changes to the transmission mechanism since the financial crisis. An important reason for thinking that the impact of rate rises will be more delayed this time is the rise of fixed-rate mortgages: more than £9 out of every £10 lent in 2022 was at a fixed rate (96 per cent) whereas this was just £4 in every £10 (41 per cent) from 2004 to 2006. So we also look at how much of the rise in interest rates has fed through to higher mortgage payments. To do this, we use updated estimates taken from our recent work on the impact of rate rises on mortgage repayments. These suggest that only around a third (36 per cent) of the impact should be evident in the data. All this suggests between half and two-thirds of the impact of higher rates is yet to show up in the data. Figure 6: Only around a half to a third of the of the impact of past interest rate increases are evident in the data by June 2023 The UK labour market is already loosening more rapidly than elsewhere with more to come. Figure 7 shows the tightness of the labour market – the ratio of vacancies to unemployment – and extrapolates the loosening in the labour market that is in train from the rate rises already announced. Based on historical estimates of the impact of changes in interest rates – with around half of the impact already in the data – the tightening in train should be enough to return tightness to 2015 levels. Based on the Phillips correlation over the pre-pandemic decade (Figure 4, left panel), that would be enough to push down wages by around 2 percentage points. But if only around a third of the rate-rise impact has so far come through, it suggests the labour market will loosen to a degree not seen since the depths of the financial crisis. Figure 7: The UK labour market is loosening faster than elsewhere and is set to loosen further as the delayed impact of higher interest rates comes through All this suggests that the Bank of England is less likely to adopt a ‘high for long’ strategy, keeping rates above 5 per cent for a prolonged period, than the Fed. Indeed, the Fed has indicated it is prepared to keep interest rates above 5 per cent until it is clear that high inflation has been squeezed out of the system. This, along with recent hawkish language from the Bank, has raised expectations that the Bank of England may adopt the same approach. But our analysis suggests that, with the labour market loosening rapidly already, and with the majority of the impact of rate rises still to show up in the data, there is already a risk that the Bank of England has overdone its tightening. If that proves right, the Bank is likely to be cutting rates below 5 per cent much more quickly than the Fed, and this would provide relief to around 3 million households, who face the prospect of average increases in their mortgages of nearly £3,000.  Wage growth of 3.5 per cent is consistent with price rises of 2 per cent if productivity is growing at an annual rate of 1.5 per cent.