Farewell transmission: Have interest rates worked to bring down inflation?

Markets are growing increasingly confident that the Bank of England will cut interest rates in June, yet economists are not sure how much of an impact the interest hikes have actually had.

As inflation took off in the aftermath of Russia’s invasion of Ukraine, central banks all over the world started aggressively hiking interest rates.

The Bank of England has hiked rates from just 0.1 per cent in December 2021 to a post-financial crisis high of 5.25 per cent. Economists feared that unemployment would have to rise sharply as a result and the economy to contract in order to bring inflation back under control.

This has not happened.

While inflation has fallen from a peak of over 11 per cent to 3.4 per cent, unemployment stands at just 3.9 per cent having fallen in the second half of last year.

And yes there was a recession, but it was the shallowest on record and timelier survey data suggests the UK is already emerging from its 2023 downturn.

Andrew Bailey, the Bank’s governor, noted this trend with some surprise. “The pattern of disinflation with full employment is unusual in our modern history,” he said.

Archie Norman, chair of M&S, went further, describing monetary policy as “totally ineffective”.

Norman’s position is a bit extreme. It seems extremely unlikely that inflation would have come down as quickly as it has if the Bank Rate was still at 0.1 per cent, as it was in December 2021.

Nevertheless, it is clear monetary policy has not worked as policymakers intended it to. So what’s changed?

Mortgages

Douglas McWilliams, deputy chairman of the Centre for Economics and Business Research (CEBR), said “by far the biggest change” was the changing structure of the mortgage market, in particular the rise of fixed-rate mortgages.

The proportion of mortgagors who are on fixed-rate mortgages has risen from under 30 per cent in the early 2000s to around 85 per cent. The length of time people are deciding to fix their mortgages has also become longer.

This means many mortgage holders have been largely insulated from higher rates. McWilliams said the growing popularity of fixed-mortgages had “cushioned the blow” from higher rates.

This may mean there’s worse to come. At the end of last year, around 45 per cent of fixed-rate mortgage deals agreed pre-2021 were yet to renew, but with rates coming down they will not face the same shock as those refinancing a year ago.

Pandemic

“This is not a typical cycle,” Andrew Bridgen, chief economist at Fathom Consulting, said. “What we’re going through is still a response to the pandemic”.

The pandemic has had a huge impact on the effectiveness of monetary policy. For a start, households accumulated record amounts of savings during the pandemic because they were essentially forced to save

According to Fitch, UK households have accumulated £280bn of ‘excess’ savings since the start of 2020, nearly 11 per cent of GDP.

Higher interest rates mean those households receive extra income on their savings. Those benefits accrue almost immediately – unlike the delayed impact from mortgages.

This means households have actually earned more from higher rates than they have had to pay out in higher mortgage costs, the first tightening cycle in which this has been the case. Research from the Resolution Foundation at the beginning of this year suggested households had seen a net interest boom of £16bn.

The flipside of increased savings over the past few years is that households want to spend. “People are trying to make up for lost time,” Bridgen said.

Wealthier people have clearly seen more of the benefits of higher rates without the costs, which some have suggested has kept spending higher than it otherwise would have been.

“Putting up interest rates a little bit won’t prevent them from going out to eat the meals they couldn’t eat and the holidays they couldn’t go on,” Bridgen said.

This is why spending on areas like travel and hospitality is actually higher than pre-pandemic.

Catherine Mann, a member of the Bank’s rate-setting Monetary Policy Committee, said people on higher incomes were spending “disproportionately” on travel and eating out which was keeping services inflation elevated.

“There is not a lot of consumer discipline on a large enough fraction of categories of services to represent active deceleration in services price inflation,” she said.

Services inflation remains at over six per cent, more than twice the level policymakers think is consistent with inflation falling to target.

 McWilliams preferred to focus on the role of competition rather than the consumer. “There does not seem to be enough competition in the market to discipline firms,” he said.

Whatever the cause, firms do not seem to have faced the same pressure to slow price increases as in the past.

Unemployment

These factors help to explain developments – or lack thereof – in the labour market.

The labour market is closely watched by policymakers for signs about how interest rates are transmitting to the economy. It is traditionally seen as a late-cycle indicator, meaning it takes a fairly long time for rates to filter through.

Even so, unemployment fell in the second half of last year (if you believe official figures). That was not supposed to happen.

McWilliams suggested that unemployment and inflation were perhaps not as closely related as economists have thought.

“High rates of unemployment had remarkably little impact on inflation in the 1980s, just as low levels of unemployment don’t seem to be having much of an impact now,” McWilliams said.

“Its the same trend, but turned upside down”.

This is not to say that the labour market is not important. But perhaps it is better to focus more on the demand side. Here there has been a noticeable impact.

The number of vacancies has fallen for 20 consecutive quarters – the longest decrease on record.

Slowing demand for labour has allowed pay growth to slow fairly quickly without an increase in unemployment, lowering costs for businesses and giving workers less money to spend.