This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.
Inflation is now down to 3.4 per cent. In all likelihood the Consumer Prices Index (CPI) will drop below 2 per cent by the summer. That is good news: it means that earnings will at last be running well above price increases.
However, do not expect any sharp fall in interest rates or the cost of mortgages. Yes, rates will come down right across the developed world in the coming months, including here. But the general cost of borrowing will remain much higher than it was from early 2009 and the spring of 2022, when the Bank of England kept its base rate below one per cent. Those days are long gone.
Why? First of all, this decline in inflation is not yet secure. The headline rate for the CPI is falling mainly because the huge increase in energy prices over the past two years is now unwinding. The oil price at $86 per barrel for Brent crude is actually a little lower than it was on the eve of Russia’s invasion of Ukraine in February 2022.
Expensive energy affected everything, from fertiliser and food through to transport and heating. Businesses had to pass those costs on. Now that is in reverse. Producer input prices – that is what companies have to pay for the goods and raw materials they buy – were actually 2.7 per cent lower than they were a year ago. Their output prices, what they charge for their products, were up 0.4 per cent. That is because they have other costs, notably wages, which are going up by more than 5 per cent a year.
There is good and bad news here. The encouraging bit is that the near-zero rise in output producer prices will feed through into consumer prices, and that is why most economists think the CPI falls to 2 per cent in the summer. It is possible we may get there before the US and Europe. The less positive news is that while goods prices are indeed rising very slowly, inflation in the cost of services is still running at more than 6 per cent. Unless that comes down sharply, as we move from summer to autumn the headline CPI number is likely to push back up.
You see the problem for the Bank of England. It will meet its target of 2 per cent inflation – a target that Rachel Reeves, shadow Chancellor, confirmed this week that an incoming Labour government would keep. But the Bank will be frightened of cutting interest rates by too much, in case, come next year, the CPI number bounces back up.
We will see what Andrew Bailey, its Governor, has to say about interest rates after the Bank’s Monetary Policy Committee meeting on Thursday. Do not expect any change in rates, for that is extremely unlikely. Look instead for signals about the timing of the first cut, now expected by the markets to come in June.
There is another reason for caution about the cost of home loans: what happens in the gilt market. Tracker mortgages, those that are set a certain amount above the Bank’s rate, will be held higher by this caution about the future path of inflation. Fixed-rate mortgages will depend on what lenders have to pay for longer-term funds, and those rates are set by the price that the Government has to pay to borrow by issuing bonds, aka gilts.
So someone wanting to get a five-year fix on their mortgage is competing against the Government wanting to borrow for the same period. The same principle applies to a two-year fix or a 10-year one.
I am afraid that the Government has a better credit rating than the rest of us, so we are charged a premium over whatever HMG has to pay. How much? Lenders have to pay a bit more than the Government and they have to add in their own costs and profit margin. If you want a round number, it works out at about one percentage point higher.
That is why earlier this year there was a spate of cheaper mortgage deals that have now rather dried up. Last summer, the yield on five-year gilts shot up to nearly 5 per cent, which made a five-year fix very expensive. But in January the yield dipped down below 3.5 per cent, so there was a string of offers. Now it is back to 3.9 per cent, which means that according to Rightmove, the average five-year mortgage rate is 4.85 per cent.
No one knows what will happen to gilt yields in the coming months, but since the Government’s budget deficit looks like being well over £100bn this year, it is unrealistic to expect longer-term interest rates to fall very much. It also means every homebuyer has a self-interest in this and future governments getting the fiscal deficit down.
So while the progress in cutting inflation is unambiguously encouraging, the benefits for homebuyers and indeed all other borrowers will be much more limited – and will take a long time to come through.
Fiscal responsibility was one of the big themes in Rachel Reeves’s Mais Lecture on Tuesday evening. I went to see her because, while of course all of us to can read her words or watch a clip, you get a better sense by watching in person how someone handles themselves and the audience. She is, after all, most likely to be our next chancellor, and this was her first major opportunity to set out her stall. So what were my impressions?
Well, the speech was very political and very long, and I suspect that quite a bit of the dog-work was done by her staff. There were a lot of references to economists and a lot of detail about their work that might support Labour’s aims.
The fiscal responsibility theme was similar to that of Gordon Brown before he took office – only borrow for investment, not for current spending over the cycle – though with an additional commitment that it would all be approved by the Office for Budget Responsibility. More important was the passage about how planning controls were holding the country back, and if a new government really tackled that, the effect on growth could be huge.
Indeed, it was the most pro-growth speech I can recall from a would-be chancellor, or one in office. So the question really is whether in practice the outcome would match the rhetoric. There were a lot of references to growth performance under New Labour, but unsurprisingly no comment as to how it had inherited a deficit that was falling towards 3 per cent of GDP (and which would shortly move into surplus), and had left office with one of 10 per cent.
The inheritance of the next government will not be as favourable as that of 1997, but if inflation comes down and growth recovers, as I expect to happen, it looks like being much better than the shadow Chancellor sought to portray. It was rather a classic case of a new chief executive saying that their predecessor had left a terrible mess and they would set out to clear it all up.
Was it credible? Well, yes and no.
Yes, because Reeves went out of her way to reassure not only on fiscal policy, but on labour market policy too. She softened Labour’s commitment to tighten worker contracts by noting that she did not want to damage labour market flexibility by checking employers’ willingness to hire. So not too much to scare the business community.
But no, because there was nothing apart from planning reform that was really likely to boost growth, and no acknowledgement that New Labour had passed on to the Coalition government the worst fiscal deficit in peacetime.
Journalists are pretty sceptical about politicians’ claims, and those of us to have been around a bit are more sceptical than most. It is always difficult to make a judgement of a new chancellor when they come in. I have had to try and understand 18 of them, so Rachel Reeves would be number 19 and a very welcome first woman to do the job.
But I thought I had better check my reservations with a colleague on another paper who had been in the trade almost as long as I. He said he would give her seven out of 10 – alright but nothing special. That would be my call too. But maybe that is good enough. If Labour does get to form the next government, let’s hope so.
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.
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