Gianluca Benigno is professor of economics at HEC Lausanne, and formerly head of international research at the NY Fed.
The UK inflation rate hitting Bank of England’s 2 per cent target for two consecutive months has finally allowed the central bank to cut rates today, for the first time since Covid-19 infected the global economy.
As the Monetary Policy Committee said in its statement:
It is now appropriate to reduce slightly the degree of policy restrictiveness. The impact from past external shocks has abated and there has been some progress in moderating risks of persistence in inflation. Although GDP has been stronger than expected, the restrictive stance of monetary policy continues to weigh on activity in the real economy, leading to a looser labour market and bearing down on inflationary pressures.
However, with interest rates still at 5 per cent — far higher than the current inflation rate, and pretty restrictive given anaemic economic growth — it is natural to question why the Bank hasn’t acted sooner, and more forcefully.
One significant concern for the Monetary Policy Committee is the persistence of services inflation in the UK. Despite the overall inflation rate reaching its target, services price growth remains stubbornly high even as goods inflation has slowed markedly and is now in negative territory.
Services inflation staying unexpectedly high was one of the reasons why four members of the MPC actually voted to keep the policy rate at 5.25 per cent.
As the minutes from the July 31 meeting note:
Four members preferred to maintain Bank Rate at 5.25% at this meeting. The upside news to services inflation and GDP outturns relative to the May Report, along with continued elevated wage growth, suggested that second-round effects were having a greater impact on wage and price-setting behaviour in the economy beyond what was embodied in the modal forecast. External factors, such as international food and energy prices, had played the major role in reducing headline inflation to date. By contrast, underlying domestic inflationary pressures appeared more entrenched.
These members thought that there was a greater risk of more enduring structural shifts, such as a rise in the medium-term equilibrium rate of employment, a fall in potential growth and a rise in the long-run neutral interest rate, contributing to domestic inflationary persistence. They preferred to maintain the current level of Bank Rate until there was stronger evidence that these upside pressures would not materialise.
So, why is service inflation still so persistent despite patently restrictive monetary policy? One reason might be monetary policy itself.
A significant component of service inflation is housing rents. As interest rates rise, so do mortgage rates. Many landlords pass these increased costs on to tenants through higher rents. This creates a Catch-22 for the Bank of England: keeping rates high for longer could actually entrench service price inflation.
Let’s examine this channel in more details in a step-by step fashion. Given the structure of the UK mortgage market, there is a high co-movement between the policy rate that the Bank of England sets and the reference mortgage rates faced by homeowners.
Here are the two longest time series for mortgage rates for households, the sterling lifetime tracker and the sterling revert-to-rate. As you’d expect, the steep increase in the policy rate has been accompanied by a parallel increase in the reference mortgage rates.
Idiosyncratic traits of the UK rental market, such as the shorter length of mortgages and the substantial buy-to-let sector (about 19 per cent of UK households are private renters, and about 45 per cent of them live in a home with a BTL mortgage) play a crucial role in the transmission mechanism of monetary policy.
Unlike the US — where mortgage contracts are typically fixed for longer periods, track long-term Treasury yields and are therefore less sensitive to policy rates — UK mortgages are more directly affected by rate changes.
This influence is evident in the housing component of CPI inflation. As mortgage rates in the UK have risen, so has the actual rental component, with rent inflation climbing from 6.5 per cent at the end of 2023 to 7.2 per cent in June 2024.
Landlords that face a steep increase in their mortgage rate (if they are on variable rates) or face a higher reset rate naturally push these higher mortgage costs on to tenants. This is particularly true in the current context, where interest rates have raised rapidly in a relatively short period of time.
As the Bank of England’s quarterly bulletin highlighted:
The CPI measure of rents . . . 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.
Moreover, it’s worth noting that “actual rents for housing” is not just a direct component of CPI but could also be associated with higher costs for businesses that rely on commercial rentals.
The Bank of England isn’t oblivious to this argument. In December two economists in its monetary policy division published a blog post examining the topic, arguing that while higher rates should decrease rents “in the long run”, they could “initially” push costs higher.
In our analysis, a temporary rise in interest rates leads to temporary increases in rental yields, as happens for returns on other assets in the economy. Tenant demand rises at first and landlord supply may be dampened by rising mortgage costs and slow adjustment of house prices. However, over time, our results indicate that the housing market should adjust, causing rental prices to decline.
As Keynes quipped, in the long run we are all dead. And despite the Bank’s protestations it seems pretty clear that higher rates are leading to higher rents, and that is in turn contributing to the slower adjustment of services inflation.
Services inflation makes up 45 per cent of the UK CPI rate, with actual housing rents being the largest component. Housing rents account for 17 per cent of overall services inflation, meaning a 1 per cent increase in rents translates to approximately 0.17 per cent rise in services inflation.
As mortgage rates reset and remain high, increased rental costs propagates into the economy, particularly affecting sectors dependent on rental properties. When rental costs enter as input costs in these sector, they further contribute in slowing down the adjustment of services inflation.
Given the lags in mortgage rate adjustments, it wouldn’t be surprising to see this mechanism contributing to a painfully slow adjustment to services inflation. And holding rates higher for longer can only contribute to make it more persistent, rather than taming it.
Given the other disinflationary forces at work, the Bank of England should not be afraid to let today’s rate cut be the beginning of a sustained easing cycle.
Further reading:
– So long, and thanks for all the fixed-rate mortgages? (FTAV)
– Britain, land of the eternal mortgage (FTAV)
– Andrew Bailey vs the renters? (FTAV)
