Is inflation now under control in the UK and US?

On both sides of the Atlantic, the central banks have taken their economies on a wild inflationary ride. Their primary aim to keep inflation at around 2% to maintain economic stability but, after a period of stability following the banking crash of 2008-9, they allowed inflation to soar to around 10% – or five times target.

UK inflation reached 11.1% and the US 9.1%. Both have now presided over its fall, with UK Consumer Price Index (CPI) inflation back at 2.2% and the US at 2.9%. Both have argued that the Ukraine war caused disruption to energy and food supplies which drove up prices. It was an external shock which they could not predict which accounted for much of the problem, they argued. But this does not explain why inflation was high and rising before the war broke out.

Both the Federal Reserve (Fed) and the Bank of England (BoE) pursued a very lax monetary policy in response to the Covid-19 pandemic. Before the Ukraine war, central banks recognised the dangers posed to incomes, output and financial market stability by the unprecedented lockdown of large sections of their domestic economies to limit the spread of the pandemic.

The central banks took interest rates down to around zero and, at the same time, announced substantial money printing programmes to buy up bonds. This action served to lower longer-term interest rates as well as the short-term rates the central banks fix through their policy deliberations. It also put cash back into markets as financial institutions and investors could sell bonds easily to raise cash or to reinvest.

Was the stimulus overdone?

A large intervention in March 2020 was essential to stabilise markets and to help finance business and government programmes through lockdown. It is also possible they carried the stimulus on too long and on too great a scale into the period of recovery as the restrictions were lifted. Inflation in the UK was already three times target before Vladimir Putin sent his troops into Ukraine.

Asset and house-price inflation set in on the back of large quantitative easing programmes, which involved buying government buying. People and institutions bid up other assets as they sought to reinvest their cash from selling some of their bonds to the central banks. Mortgages were cheap and governments could borrow huge sums at tiny rates of interest to sustain their increased spending and enlarged deficits.

When rising inflation was obvious, they shifted policy dramatically. The Fed took interest rates from around zero in the first quarter of 2022 to 5.25% in July 2023. It shifted from buying bonds to letting the portfolio run off. The Fed’s balance sheet reached a peak of $8.96 trillion in April 2022, falling to $7.17 trillion by August 2024.

The BoE took interest rates up to 5.25% and reduced its holdings of bonds from £895bn to £728bn by the end of March 2024. It has been selling bonds at a loss in the market as well as running the portfolio down as holdings mature.

The Fed and BoE squeezed the money supply. The Fed had to temporarily ease off on the inflation fight to avoid some of its regional banks getting into trouble. The BoE had to temporarily revert to quantitative easing again to overcome a crisis in the Liability Driven Investment funds market.

Labour markets and wages remain key

The US and UK labour markets had been looking similar. There had been strong jobs growth, an excess of job vacancies, rapid inward migration by job seekers, and a large pool of people at home not seeking jobs. Pay rises were strong, and a major concern for central banks as jobs markets remained tight.

The latest job figures show some divergence between the two countries. The US job market is now slowing. In July, unemployment rose from 4.1% to 4.3%, increasing by 352,000 to 7.2 million people. Labour participation was at 62.7%. Private sector earnings rose a more modest 3.4% year on year. These figures now look sufficient to allow the Fed to make a cut in rates as markets are expecting.

The UK reported unemployment down to 4.2% from 4.4% in the latest three-month period and was as low as 3.6% in the month of June. Pay growth has slowed but was still at 5.4% - which is not a compatible with a 2% inflation if it persists. However, markets are now looking at the downtrend more than the level, expecting UK private sector pay increases to continue to moderate now inflation is close to target.

The UK has 9.5 million people of working age but not in employment, but only 1.8 million of these may want a job. Of these, 2.5 million are students, 1 million have taken early retirement and 1.7 million are looking after family and home. The government is promising new measures to help more people into work, which would alleviate tightness in the labour supply.

UK CPI inflation rose from 2% to 2.2% last month and the government’s preferred measure - Consumer Prices Index including owner occupiers' housing costs, (CPIH) rose to 3.1% with a 7% increase in owner-occupied housing costs. Service sector inflation fell from 5.7% to 5.2%, which is still high but is nevertheless going in the right direction.

Likely interest rate changes

The general view is the BoE will be able to make another 25-basis-point (bp) cut later this year, but it should take a further slowing wage growth for this to be well based. The Fed is likely to start cutting rates in September. Some market expectations of the pace of cuts in the cost of borrowing look ambitious, as the two economies are not as weak as some feared.

The UK government is currently settling several long outstanding public sector disputes by offering considerably higher pay. Markets will need to watch to see if this has a knock-on effect to private sector settlements.