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●   Scaling back our forecast for UK rate cuts: As labour cost inflation is still elevated and will likely only moderate gradually amid robust domestic demand, we scale back our forecast for interest rate cuts in the UK. We now expect one more cut in bank rate this year – in November – and three more in 2025 to take the policy rate to 4% by end-2025. Previously, we projected that the Bank of England (BoE) would reduce its key rate to 3.5% by mid-2025.

●   Odd one out: The BoE will likely be an outlier in September as we expect it to maintain its policy rate at 5%, while the US Federal Reserve (Fed) and the European Central Bank (ECB) look set to reduce their interest rates by 25bp. Heightened caution on the part of the BoE is justified, in our view. It already bolstered the pound to a two-year high of $1.33 in late August.

●   Reason to hesitate: While UK consumer price index (CPI) inflation fell close to the 2% target in recent months (albeit increasing from 2% yoy to 2.2% yoy in July), it was dragged down by negative energy price inflation as utility bills continued to fall back from their peak at the end of 2022. That offset larger increases in prices for services. Chart 1 shows that core inflation (excluding energy, food, alcohol and tobacco) stayed above 3% in July, while services inflation remained above 5%. In contrast, services price inflation has fallen below 4% in the US and the Eurozone.

●   Labour cost pressures still in the pipeline: Labour is the main input in the production of services. As a result, services price developments are broadly determined by pay growth adjusted for increases in workers’ productivity and changes in firms’ margins. As CPI inflation averaged 2.2% between 2010 and 2019, we use that period as a guide to the target-consistent pace of pay and productivity growth, denoted by the black lines on Chart 1. Pay continues to rise by about 5% yoy compared to about 2% yoy in the 2010s, while worker productivity is increasing more slowly than in that decade. As a result, the cost of labour per unit of real output, known as unit labour cost, has risen sharply over the past year.

●   Pay growth today, inflation tomorrow: Headline total pay growth eased from 5.7% yoy in May, to 4.6% in June. However, the decline was caused by a base effect due to high bonuses a year earlier. Timelier and less volatile measures of wage growth show stronger momentum in wages – eg qoq annualised growth in regular pay remained more elevated at 6.5%. Moreover, the government has approved above-inflation pay rises for public sector workers, which will prevent private sector pay growth slowing much from its current pace of 6% yoy. Barring a sudden increase in workers’ productivity, unit labour costs will continue to rise. Demand conditions will decide whether firms accept higher labour costs squeezing their margins, pass the cost increase on to consumers, or cut production. Given positive real income growth and improving consumer sentiment, we suspect that demand will prove strong enough for companies to raise their prices.

●   Interest-sensitive activity already picking up: The increase in mortgage approvals to a two-year high in August suggests that housing market activity is picking up (see also rate cuts will lift house prices, dated 30 August 2024). Moreover, Chart 2 shows that falls in UK interest rate expectations have correlated with increases in the composite purchasing managers’ index (PMI) for the past 18 months. This suggests that the prospect of lower interest rates is also providing a broader boost to economic activity.

●   A fiscal headwind? Of course, in the prime minister’s own words, the UK awaits a “painful” budget on 30 October. However, higher taxes will fund higher spending on public services and salaries. The Labour government is expanding the share of income taken and redistributed by the state as opposed to embarking on a course of outright fiscal tightening. Therefore, fiscal policy may be less of a drag on aggregate demand than widely assumed.

 

Andrew Wishart

Senior UK Economist

+44 20 3753 3017

andrew.wishart@berenberg.com

 

 

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