Britain’s sticky inflation problem means Bank of England must push up rates

UK inflation remains stubbornly high, posing a challenge for the Bank of England. PA

UK inflation is proving to be far stickier than hoped, with the headline CPI rate holding firm at 8.7 per cent in the 12 months to May, unchanged on April’s reading, delivering bad news for Britons desperate for some respite from runaway prices rises.

The bigger issue, however, is core inflation – which strips out the more volatile items such as food, energy and tobacco. This jumped to 7.1 per cent in May, the highest rate in 31 years, presenting an even greater problem for the Bank of England - how aggressively to push ahead with its monetary tightening strategy.

The central bank now has a major conundrum on its hands ahead of its next monetary policy meeting, which concludes at noon on Thursday, as its policymakers strive to bring headline inflation back towards its 2 per cent target.

Do they continue with another gentle 25 basis point rise in the hope that previous rate rises have still to bite, but risk it not being enough to prevent inflation becoming embedded in the economy? Or go in all guns blazing with a 50 basis point rise and risk triggering a downturn by delivering a shock to borrowers?

The central bank has come under fire in recent weeks for not acting quickly or aggressively enough to quell Britain’s persistent inflation problem.

If it fails to take affirmative action on Thursday this could cause financial conditions to loosen even further and the pound to weaken, something nobody wants – least of all policymakers at the central bank.

Keeping sterling at its recently stronger levels should help to limit inflation, as it makes imports cheaper.

It’s a delicate balancing act, however, with any further interest rate rises likely to cause more pain for UK mortgage holders at a time when their finances have only just scraped through a cost-of-living crisis.

Britain’s mortgage crisis is now the country’s leading personal finance concern, with the full force of the interest rate rises only hitting first-time buyers and those whose fixed-rate mortgage deals have expired in the past 12 months so far.

The crunch point will come as more people emerge from fixed rate deals over the next few months and years and are forced to absorb significantly higher repayments.

Many Britons locked into fixed-rate deals before the BoE’s cycle of interest rate rises first began in December 2021 – securing rates as low as 1 per cent.

Thursday’s will be the 13th consecutive rate rise and those homeowners are now entering a very different mortgage landscape than the one they left.

The average two-year fixed mortgage rate surpassed 6 per cent this week, with the situation likely to deteriorate further if inflation cannot be brought under control.

The stark reality is that interest rates are now expected to peak at 6 per cent by the end of the year, potentially pushing some households to breaking point as the era of cheap money comes to an abrupt and brutal end.

While mortgage rates have historically been higher, loan sizes are now far greater relative to incomes. As mortgage costs increasingly take up a larger share of consumers’ take-home pay, this could have dire consequences for the economy as people restrict their spending to ensure they can meet their household bills.

The repercussions on the housing market could be equally dire as affordability levels get tested to the max with expectations that house prices may fall more aggressively in the coming months than the minor dips seen so far.

Mortgage rates are rising, putting a strain on household budgets. Bloomberg

Britain may no longer be expected to be the poorest performer against its global peers in the G7, after the International Monetary Fund sharply upgraded its growth forecast in May, but it is still on track to have the highest inflation rate in the developed world, according to the OECD. This is exacerbated by strong wage growth as employees demand bumper pay rises to help keep pace with rising prices.

The government is now on a mission to “squeeze every last drop of high inflation out of the economy” as it strives to hit Prime Minister Rishi Sunak’s January pledge to halve inflation by the end of the year from the 10.7 per cent it stood at in January.

For that mission to stay on track it requires aggressive action, which is why all eyes are now firmly pinned on Threadneedle Street in the heart of the City of London and Thursday’s interest rate decision.

Alice Haine is the Personal Finance Analyst at Bestinvest, the DIY investment platform and coaching service