BoE rate decision complicated by UK inflation jump and banking turmoil

Due to the unexpected rise in UK inflation and turmoil in global banking, Bank of England rate-setting staff will have to make a tougher decision on Thursday.

newest data showing 10.4 percent inflation has raised concerns that rising prices are being driven more by domestic pressures than external shocks like high energy prices.

These pressures tend to be stronger and last longer, so the market has been reassured that the BoE will increase interest rates.

However, in the past fortnight, concern over the state of the global banking industry has intensified. While there is no evidence to suggest that the UK has an issue, central banks insist that financial stability will not be in jeopardy for their inflation-fighting mandates. However, banks are likely to be more cautious about lending due to the rising tensions in the financial markets. This would decrease the need to increase interest rates.

James Smith, Resolution Foundation research director, said that the surprise inflation increase last month will complicate the decision making of monetary policy committee members about what to do with interest rates as they deal with banking sector turmoil.

One-off factors like the weather-related shortages in lettuce and cucumbers that led to empty shelves at UK supermarkets and drove up the prices of food and other non-alcoholic beverages at their fastest rate in 45 years, partly explained the surprise rise in February’s inflation data.

However, price increases were widespread, even in hospitality sectors where labour costs are a major factor. The annual services inflation which is a better indicator of domestic price pressure, rose to 6.6%. It reached its highest level ever in the hospitality sector.

After closely following it for much of the past year, UK core inflation rose to 6.2%. It is now 0.7 percentage point higher than that of the US.

The UK is unique among major economies because of its high inflation rate. Only a marginal slowing of the rate from the 41-year high of 11.1 percent last October has been seen, while the gap between Britain’s economy and that of the US and the eurozone has increased.

Krishna Guha, an economist at Evercore’s investment bank advisory firm Evercore, stated that the acceleration in core and services inflation indicates that there may be more domestically-generated inflation pressure than what the Bank has assessed.

Kallum Pickering of investment bank Berenberg said that the BoE’s decision on Thursday will be influenced by whether policymakers believe the backward looking inflation surprise is likely the beginning of a trend, or if it is a one off linked to normal monthly volatility.

He pointed out that Wednesday’s data were released after inflation had slowed further than anticipated in January. He also said that “caution still favors a hold” by BoE since raising rates before the full effect of global monetary policy tightening has occurred “risks adding problems that would eclipse those associated excess inflation over medium term”.

The UK’s housing market is already suffering from rising mortgage rates. “The risk is that a hike now might end up pushing inflation lower than target further down”, Susannah Streeter, head money and markets at Hargreaves Lansdown.

There are concerns that the “banking scare” will lead to a disinflationary effect by causing a knock-on effect to lending, which could impact spending by companies and consumers if loans become more difficult to obtain.

Markets now anticipate a 25-basis point increase in rates from the BoE, which was closer to stopping them than any major central bank prior to the current banking crisis.

This would mark the 11th consecutive rate rise since November 2021. The central bank increased rates by 0.1 percent by almost 400 basis points to 4% in an attempt to reduce inflation to the 2 percent target.

The main driver of inflation in the UK for the majority of the past year was the UK’s energy prices. However, they are not falling enough to offset increases in other items. The prices of fuel dropped by 1.3% between January and February, and the annual pace of inflation slowed to 5.1% last month from a peak of 45.8 percent in July 2022.

Despite slowing down, UK energy inflation is still much higher than the US and eurozone. This is due to differences in government support and country’s exposure on the international energy market.

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