Should the BoE follow the Fed?

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The Federal Reserve (Fed) started its easing cycle with a bang. In its September meeting, the bank cut its key interest rate by 50 basis points (bps) to a range of 4.75%-5%, citing an uncertain economic outlook. With more confidence that the inflation battle has been won, the Fed signalled further bold action in the coming months, appearing keen to step off the brake and get interest rates down to a ‘neutral rate’ closer to 3% as soon as possible. Following this signal, the market expects an additional 200bps of cuts by this time next year.

Can mortgage holders in the UK expect similarly large cuts from the Bank of England (BoE)? The market seems to think so, although at a more gradual pace. The UK Bank Rate is expected to be 150bps lower by the end of next year.

I believe the market has this wrong. The UK economy is simply not behaving as well as the US.

The problem is the differences in the two labour markets. A combination of massive migration – 3.7m workers to be precise – and rising domestic participation has given rise to a phenomenal expansion in the US workforce.

Finding themselves in a weaker bargaining position, workers have stopped pushing their employers for much higher wages, taking the heat out of the US labour market.

For firms, the news is even better because in addition to labour becoming less expensive, it has also become more productive. Consequently, the growth in unit labour costs – the cost of delivering additional goods and services from existing workers – has barely increased in the US.

As a result of both reduced wage pressure and flattening unit labour costs, US inflationary pressures have eased substantially.

Sadly, the UK is experiencing the opposite.

UK domestic participation is actually lower than it was pre-pandemic, with 7% of the entire UK workforce not working due to long-term sickness. Those that are participating in the workforce therefore continue to have significant bargaining power.

On top of this, productivity in the UK is entirely stagnant in stark contrast to the US.

The culmination of robust wage growth and weak productivity has been rapidly rising unit labour costs for UK firms.

With little sign that either the participation or productivity problems will be solved in the near future, inflationary pressures will remain strong unless the UK witnesses a collapse in demand. This is possible but it’s hard to see the catalyst. Despite a dip in UK consumer confidence in September, it has been on an uptrend for much of this year and business surveys all speak to reasonable demand.

Overall, I think the UK economy has displayed significant differences to the US, which puts the BoE in an entirely different boat to the Fed and likely prohibits it from mirroring the large rate cuts that are expected across the pond.

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