Economic Update: Have interest rates peaked?

The Bank of England left interest rates unchanged at its recent policy meeting after a series of increases, reflecting falling inflation and weakening growth prospects.

This Insight reviews recent developments in inflation and wages, and considers the outlook for economic growth. It also provides an overview of recent upward revisions to GDP data.

Interest rates unchanged but at 15-year high

After increasing interest rates at 14 consecutive meetings since December 2021 (shown in the chart below), the Bank of England’s Monetary Policy Committee (MPC) decided to leave rates unchanged in September.

The decision was close, with five members of the MPC voting to leave its benchmark bank rate at 5.25% and four voting for another increase. The debate within the MPC reflects the current uncertainty around the economy and the inflation outlook.

Following the MPC’s decision, financial markets and economists expect that rates will peak either at the current 5.25% or after one further increase to 5.5%.

Inflation falling but still high

The inflation rate – measured as the annual change in the consumer prices index (CPI) – has been falling since it peaked at 11.1% in October 2022; it was 6.7% in August 2023. This means prices are still rising but more slowly than before.

While the overall inflation rate has been falling, measures of underlying inflation in the economy rose in the first half of 2023. For example, inflation in services was recently at a 31-year high of 7.4%. Services inflation is less exposed to global developments (like energy prices) and therefore more dependent on domestic factors, such as wage growth and consumer demand.

However, the latest inflation data release from the Office for National Statistics (ONS) showed services inflation falling from 7.4% in July to 6.8% in August. Core inflation, which excludes food and energy prices, also fell, from 6.9% to 6.2%. Both measures are at their lowest rates since March, as shown in the chart below.

The inflation rate is expected to fall towards 5% by the end of the year, mostly due to past sharp increases in energy bills not being repeated this year – this results in those past increases “dropping out” of the annual inflation calculation.

Although inflation is falling, it is still well above the Bank of England’s 2% target. MPC members who voted to increase rates to try and further suppress inflation cited the fact that these underlying inflation indicators are still high.

More information on inflation is provided in the Library briefing on the rising cost of living.

Labour market starting to cool

Wage growth is one area policymakers are keeping a close eye on, as for many firms it accounts for a large proportion of their costs, at least some of which may be passed on to consumers via higher prices.

Average pay has been rising at a fast pace, though until recently it was not keeping up with inflation. Annual wage growth excluding bonuses was 7.8% in the period from May to July 2023, up from 5.2% in the same period a year before and the highest it has been for decades (excluding the statistically distorted pandemic period).

However, there are some indications that the previously persistently strong labour market has recently weakened. ONS data for May to July 2023 compared with the previous three-month period (February to April) showed that:

• The unemployment rate rose from 3.8% to 4.3%
• The proportion of those aged 16 to 64 in work decreased from 76.0% to 75.5%
• The number of job vacancies continued to decline from past very high levels.

A weaker labour market could lead to slowing wage growth and less risk of inflation remaining persistently above the MPC’s 2% target.

Concerns over growth outlook

Another important consideration for the MPC when setting interest rates to control inflation is how strong economic growth is.

Generally speaking, the faster economic activity is rising, the more likely inflation is to stay high. Increasing interest rates raises the cost of borrowing, reducing economic growth and inflationary pressures. The MPC notes that previous rate rises “were expected to weigh increasingly on the economy”.

With some fluctuations, GDP has only increased a little since early 2022. Because the UK is a large net importer of energy and food, some thought the UK would fall into recession due to soaring energy and fuel prices after Russia’s full-scale invasion of Ukraine. That hasn’t happened yet, with the economy proving to be resilient.

However, some recent economic indicators show signs that economic activity is weakening. For example, a closely watched indicator of private sector economic activity, S&P Global’s purchasing managers’ index, has been weakening and in September recorded its fastest rate of decline since January 2021 (PDF).

The MPC thinks that the economy will still grow by 0.1% during the third quarter of 2023, though that’s lower than the 0.4% growth that it forecast in August. Underlying growth in the second half of 2023 is also expected to be lower than it previously forecast.

Revisions to GDP growth during pandemic

Meanwhile, the ONS announced that it would be revising up its GDP growth estimates for 2020 and 2021. The ONS said that better information from a business survey on the costs firms faced in the pandemic was a key factor behind the changes.

At the time of writing, these new figures only go up to the end of 2021. GDP growth was revised up from -11.0% to -10.4% for 2020 and from 7.6% to 8.7% for 2021. A full set of data will be published by the ONS on 29 September.

Other countries have also been revising their GDP higher for the years of the pandemic, as more detailed information becomes available.

About the author: Daniel Harari is a researcher at the House of Commons Library, specialising in UK and international economies.

Photo by Robert Bye on Unsplash