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Market Insight: Summer 2023

What’s happening to inflation, interest rates and pay?

Inflationary pressures, which had their origin in the surge in energy prices, are now firmly embedded across the board. The annual Consumer Price Index (CPI) rate of inflation, which measures the pace of price rises for goods and services, was unchanged at 8.7% in May. Core inflation, which excludes more volatile food and energy prices, rose again to 7.1%, up from 6.8% the previous month.   

These numbers sounded alarm bells at the Bank of England and the Treasury – policymakers had hoped to halve inflation by the end of the year. The Bank’s Monetary Policy Committee voted seven to two in favour of raising the base rate to 5% -  in the 13th consecutive increase.

The latest cycle of base rate hikes, which began in December 2021, has been the second-longest such cycle since at least 1975, featuring no fewer than 13 of the 18 base rate changes of the past decade.

The focus of concern is now shifting from energy prices towards the strength of the labour market. Rising wages are supporting demand in the economy, which, in turn, is pushing up price inflation in service industries, such as the hotel, restaurant and entertainment sectors.

Wages have risen at their fastest rate at any time over the past 20 years (excluding the pandemic). The average increase (excluding bonuses) in the three months to April was 7.2%, but this is still lagging behind inflation – which is why households are feeling the pinch. 

What's the outlook on the economy?

The higher rates rise in the attempt to curb inflation, the bigger the risks of recession in 2024.  Markets now expect the base rate to peak around 6.25% by the end of this year.

Inflation is expected to fall significantly for the rest of 2023, as energy prices decline. But it seems increasingly unlikely that the government will meet its target of halving CPI by the end of the year. As a result, the squeeze on households will continue.

The nation is yet to feel the full impact of the MPC’s decisions. Mortgaged households make up 30% (7.1m) of households in England, against 40% in 1989.  To date, higher interest rates have only hit a small subset of these households made up of people who are, mostly, middle-aged. Other homebuyers are on fixed-rate mortgage deals and so unaffected - for the moment.

We would argue that this is one of the main reasons why the Bank has been unable to temper inflation as quickly as hoped. The impact of higher rates on economic growth is yet to be seen, although we expect that it will slow throughout the rest of the year.

The expectation remains that interest rates will start to be cut in early 2024, particularly if economic growth slows rapidly. A key factor in the outcome will be the strength of the labour market, which, we believe, is unlikely to dissipate drastically. However, rates are likely to remain higher than most households have been accustomed to over the last few years.

What does this mean for mortgage rates?

The cost of the average two-year fixed-rate mortgage has risen to 6.19% according to Moneyfacts, up from 5.30% in May and 3.55% in June 2023.

Fixed-rate loan deals are priced in line with gilt yields which have moved sharply upwards in recent weeks in response to data suggesting that further base rate rises may be necessary. These conditions have caused turbulence in the mortgage markets, with lenders forced to withdraw deals, replacing them with new ranges at higher prices.   

Mortgage rates are dictated by the financial market’s expectations of future rates rather than the Bank of England’s decisions. The current level of rates reflects the markets’ view that the base rate will reach 6.25% by the end of the year, suggesting that mortgage rates may be at, or close to, their peak.

The outlook depends on the effect on the economy of the cost-of-living shock, and where the base rate settles. We forecast that mortgage rates beginning with 3% or 4% will be the norm towards the end of 2024.

How will this affect affordability?

Mortgage rates of 6%-7% will be a painful adjustment for hundreds of thousands of households coming to the end of cheap fixed-rate deals.

Most of these borrowers were stress tested on their ability to afford these kinds of rates. Nevertheless, the average homeowner who bought five years ago with a 40% deposit will face a monthly repayment rise of £320 (49%) if they opt for a new deal at 6%.  This is despite having built up more equity in their home through mortgage repayments and house price growth.

With a mortgage rate of 6%, the repayments on an average loan will eat up 52% of a single person’s income, returning affordability to its pre-2008 levels. But strong wage growth will soften the blow, meaning that things are not as tough as in October 2022 when rates increased in the wake of the mini-Budget.

Large numbers of repossessions remain unlikely.  The tighter lending criteria introduced in 2014 will serve to limit the number of households falling into arrears.  Lenders have learnt their lessons from the 2008 crash and will offer constructive help to struggling households.

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