Is the Bank of England in a Catch-22 Situation?
Possibly!
(image courtesy of DALL*E)
The Bank of England might be caught in a Catch-22 situation with its monetary policy, where hiking interest rates could intensify the inflation challenge.
Let’s see why:
The previous graphs plot actual rentals for housing versus CPI services on the left and versus the official Bank rate (Bank of England) on the right.
Longer time series is also quite revealing in terms of the link between interest rates, actual rental for housing, and CPI service inflation.
In this context, the Bank of England is actively monitoring and expressing concern about service inflation. This post argues that its increase and persistence could be driven by the Bank of England itself as the increase in interest rates feeds into higher rental prices. Considering this, we highlight that:
· Service inflation accounts for 45% of CPI inflation in the UK and it is quite persistent.
· Actual rental for housing is the biggest component of service inflation and the second biggest component (after food) in accounting for CPI inflation. Its weight corresponds to 17% in accounting for service inflation.
This post-analysis suggests that proactive interest rate reductions could mitigate the inflationary impact of monetary policy in this coming year.
As we navigate through 2024 there are two main risks:
· A squeeze on disposable income that could put downward pressure on consumption.
· Further stickiness in inflation arising from persistently higher rental price inflation.
However, since major central banks are tilting towards a cutting cycle, the BoE should be comfortable in cutting rates to avoid further inflationary pressures and in alleviating the pressure on households coming from higher interest rates.
Background: the transmission mechanism
What is the transmission mechanism of monetary policy? An old article from the Bank of England provides an early characterization of the transmission mechanism of monetary policy. More recently, Catherine Mann (2023) one of the external members of the Monetary Policy Committee offered an updated version of it. I highlight here her illustrative chart:
In general terms, it's noteworthy to highlight that the transmission of monetary policy occurs in two phases: initially through financial markets and subsequently impacting the real economy. I won't expand into the specifics since Catherine Mann's speech offers a comprehensive examination of the various channels and their functions. However, the underlying principle behind the transmission of monetary policy relies upon the New Keynesian perspective, wherein interest rates predominantly influence the economy's demand side.
The November 2023 Monetary Policy Report, section 3.3, suggests that “the largest component of lower demand from higher interest rates is estimated to come from household consumption, in part because consumption makes up around 60% of total GDP.” The report also highlights the lags in the transmission of the effects of monetary policy: “Overall, the impact of higher interest rates on GDP is expected to materialise with a significant lag: in the November projections, it takes until 2025 for the GDP impact to be close to fully felt.”
The following chart from the same report shows the BoE’s estimate of the different channels through which interest rates affect consumption.
Accordingly, there are three channels:
1) The mortgage cash-flow channel captures the direct impact of changes in household mortgage costs.
2) The broader housing channel that represents the impact of changes in the value of housing.
3) Other channels are summarized in the purple bars (wealth effects for example).
All these channels would be contractionary conditional on interest rate increase. Based on the Bank’s estimate the contraction in consumption has not yet fully materialized. Part of it depends on the fact that mortgage resetting is going to be more relevant from 2024 onward (see the above chart) and that the other channel has not played out as the economy has been more resilient than expected sustaining wage growth and aggregate demand.
This is the contractionary effect of monetary policy: squeezing income and then consumption.
The Inflationary Channel of Monetary Policy
It is interesting to note that in the same section on the contractionary impact of interest rates on aggregate demand, the BoE also emphasizes what is the focus of this blog post: the possibility that interest rate increases translate into rental price increases. They report this mechanism from the perspective of aggregate demand: an increase in rental prices would reduce the disposable income of renters and reduce their consumption.
“Specifically, rising interest rates increase costs for buy-to-let (BTL) landlords with a mortgage and reduce their returns through lower house prices. Landlords may try to pass on their costs through rent increases. In the long term, rent rises will be driven by household income and housing supply growth. However, given information asymmetries, moving costs, and other frictions within the rental market, landlords may temporarily have market power to raise rents”.
The next figure shows suggestive evidence that this channel might be at play especially during periods in which interest rates move significantly and rapidly: in the figure, I plot the actual rental versus the two longest time series for mortgage rates for households (the sterling lifetime tracker and the Sterling revert-to-rate).
In this context, the specificity of the UK rental market in terms of the length of mortgages and the size of the buy-to-let market (see this recent Quarterly Bulletin) could be relevant for assessing the transmission mechanism of monetary policy and its impact on inflation. This channel is relevant to the extent that it should feed into the actual rental for the housing component of CPI and contribute to the slow adjustment of service inflation and possibly CPI.
Indeed, the above-mentioned report states:
“The CPI measure of rents rose by 6.4% over the year to 2023 Q3 – the fastest pace since 1994. This measure is also a lagging indicator of the potential impact of interest rate rises on rents as it measures rent increases across all rental properties rather than the increases faced by those moving home.”
And concludes:
“But higher rents from other factors may cause households to cut back on other forms of consumption, reducing demand in the wider economy.”
This is the inflationary effect of monetary policy: keeping interest rates higher for longer could further feed inflationary pressures and delay inflation adjustment rather than facilitating it, especially at the level of service inflation.
Mitigating factors
What factors can mitigate the pressures that can come from higher rental prices?
One useful source of information comes from the Zoopla December 2023 report on the rental market. Some of the factors that have pushed higher the demand can be muted leading to a decline in the growth rate of rental prices (for example the effects of the reopening of the economy are no longer present and the softening of the labor market can also help).
According to the same rental market report, annual rental prices are projected to drop from around 9.7% in 2023 (11.4% in 2022) to about 5% in 2024, still well above the pre-pandemic average.
Moreover, despite the sustained increase in nominal wages, their increases have fallen short of the increase in rents, thus worsening affordability and possibly leading to rent reduction to attract new tenants. The latest reading of the affordability index from Zoopla is above the ten-year average and the highest since 2010.
Conclusion
What is the inflation outlook in the UK?
The BoE narrative suggests that most of the observed disinflation has been a byproduct of a reversal of supply chain shocks (see the GSCPI) and energy prices. Some risks might develop from the persistent Red Sea tensions on that front but the main concern from the Bank of England comes from the persistence of relatively high service price inflation.
How do BoE rates impact inflation?
One of the channels through which interest rates transmit to the economy is by pushing up rental prices as the mortgage rate rises. The rapid and sizeable increase in interest rates increases landlords’ costs and the likelihood that they will be passed on to tenants.
By keeping rates higher, service inflation adjustment could be further delayed: rather than taming inflation the Bank of England might exacerbate the problem that it is trying to address.
What are the BoE’s next steps?
Consider cutting rates sooner rather than later.