Inflation on the decline… the banks should be ready to immediately reduce interest rates

According to the Office for National Statistics, the UK’s rate of inflation dropped to 7.9% in the year to June, from a peak of just over 11% last year.?Yet we are expecting the Bank of England to announce a 14th consecutive rise in base rate tomorrow, with analysts predicting another in September.

It is important to remember that inflation is in fact a deflation of the value of currency. In simple terms, you need more of it to buy the same items. While the reported reduction of the rate of inflation is welcomed, it is important to understand the causes and potential consequences, as it paints the picture of how things will continue to play out, and what (if any) intervention is required.

As the injection of vast sums of money via Covid-19 relief stimulus packages of almost all major economies around the world left the planet awash with money, there is no doubt this huge increase in liquidity is the main driver of inflation. Experts reported the?Bank of England?added ￡450bn to the UK economy during the pandemic, and the Congressional Research Service claimed the US Treasury’s money printing exceeded $13trn (￡10.1trn) in response to Covid-19. So, there’s no great surprise that?inflation?has been on the rise.

In addition to this, the rising cost of fuel, driven by the war in?Ukraine, and the increase in global demand for oil as we emerged from the pandemic, have been another driver in the inflationary boom.

Supply and demand dance

This influx of cash to the system, plus a scarcity of goods and services caused by the pandemic, lead to inevitable price rises which are now starting to reduce as supply begins to satisfy demand. For some however, including Rick Rieder, CIO at Blackrock, it is suggested we should just let things play out rather than flexing the?interest rates.

As with most things, fear can often be worse than the actual event, and in my opinion, markets reacted in fear to events such as the Russia-Ukraine war, in terms of energy supply, causing demand spikes and subsequent price rises. However, as reality sets in, prices have reduced to a more stable market level.

Quantitative easing measures created a substantial increase in liquidity which drove inflation upwards. With quantitative tightening and repayment of Covid loans coming into effect at the end of 2021, this has resulted in a natural reduction in liquidity and inflation.

When liquidity is removed from the system it will naturally put upward pressure on interest rates and downward pressure on asset prices, leaving less money available to be invested. I believe that the impact of the central bank interest rate rises has not yet been realised, and the liquidity-led reduction in inflation coupled with increasing interest rates, could put us at risk of a serious deflationary position.

The interest rate conundrum

While I appreciate the pressure on the central bank to curb inflation has led to 13 consecutive hikes in interest rates in the UK, I believe that the rates are currently around 1-1.5% too high and that we have gone too far with interest. A combined central bank interest rate and large commercial bank margin of no greater than 6% should be the target in my opinion. I’d like to see the Bank of England prepared to react quickly and reduce the base rate of interest, and the commercial banks adjust their margins as inflation continues to fall – as they have done conversely over the past 18 months.

With average fixed mortgage rates as of 21st?July 2023 of 6.3% against a base of 5% currently, in contrast to July 2007, where average fixed mortgage rates were 5.2% against a base of 5.75% (a negative margin position), this 1.8% upward swing in the margin highlights the increased cost of borrowing which is creating a double hit to the borrowers, and we need liquidity and lending to continue investment.

At a time when banks are announcing record results, such as Natwest bank reporting ￡1.8bn pre-tax profit for the first quarter of the year and the Dow and the S&P 500 continue to hit record results after more upbeat earnings reports from some of the USA’s top lenders boosted the banking index, now is the time for the lenders to reduce their margins, bringing borrowing back to a more affordable rate.

Under ideal circumstances, the 2% inflation rate target sounds sensible. However, the reality is that circumstances are often far from ideal. Sometimes we may need to let the inflation rate press higher rather than put the job market and investment sectors under more pressure. With the cost of borrowing high and the mass repayment of Covid loans, the net effect is the removal of liquidity from the system of which there will be consequences.