When will UK interest rates rise again?

UK inflation is now at its highest since Labour came to power in 1997. So when can we expect to see another hike in UK interest rates?

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: sign up for Money Morning.

We have some bad news for anyone who thought UK interest rates were going to be on hold for the rest of the year.

Consumer price inflation in the UK is at its highest level since Labour came to power in 1997.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The UK's official annual inflation rate jumped from 2.2% in May to 2.5% last month. That's way above the Bank's central target of 2%, and much higher than the 2.3% expected by economists.

But never mind core' inflation was little changed, so that's all right then. Isn't it?

UK consumer price inflation has only once before hit 2.5%, back in September 2005. The Bank of England's target is 2%, with a 1% margin on either side. If it goes above 3% or below 1%, the Bank has to write a letter to Gordon Brown explaining why.

So what caused the surge? The main driver was the recent price hikes in gas and electricity bills. Other major effects came from rising vegetable prices, while the cost of lounge furniture and kitchen cabinets also went up.

The rise was much steeper than most commentators had expected. But rather than pointing to the obvious conclusion that the Bank should be getting ready for another quarter point hike many analysts tried to downplay the increase.

"June's consumer price inflation figures were undeniably disappointing. But the fact that two thirds of the rise in headline inflation from 2.2% to 2.5%...was down to food and energy prices softened the blow considerably," said Jonathan Loynes at Capital Economics.

The forecasting group, which expects interest rates to fall sometime next year amid a global economic slowdown, pointed to the fact that core' inflation that is, excluding food and energy prices - rose from 1.1% to just 1.2%.

We have a lot of time for the team at CE they are frequently ahead of the game and their comments are always worth listening to. But this concept of core' inflation - which many other economists also like to rely on - is nonsense.

The whole theory behind stripping out food and energy costs is because they are deemed to be volatile. So a spike in energy prices might cause a figure-distorting jump one month, only for things to go back to normal the next.

But as most people have noticed by now, energy prices have been distorting' inflation figures for a while now. Oil prices keep getting higher. Electricity and gas bills keep going up. Petrol prices keep rising. These aren't one-off events.

In any case, excluding energy bills from what's meant to be a core' measure of the cost of living is ridiculous particularly when other costs such as hiring a suit, or mending a shoe remain in place. We all spend money on energy every day. But when was the last time you used a cobbler?

The other big worry for the Bank is that Retail Price Inflation (RPI) is now standing at 3.3%. That's the highest since the end of 2004.

A version of RPI (RPIX - RPI excluding mortgage interest payments) was once used as the Bank's inflation-targeting measure before the introduction of CPI. Nowadays, RPI is still used to calculate increases in pensions, state benefits and index-linked gilts. That's not such a problem.

But what is more troublesome for the Bank is that employees tend to expect pay increases to fall in line with RPI rather than CPI. Which is understandable after all, just because the Government changes the way it measures inflation doesn't mean people are suddenly going to be happy to accept lower pay rises every year.

It does, however, make Gordon Brown's plans to keep public sector pay rises to around 2% seem like a pretty tough target. Asking people to go from inflation-busting pay increases to wage rises that are more than 50% below inflation is unlikely to go down well.

If unions and employees start pressing for higher wages, that will really worry the Bank. And with oil prices still rising and further hikes in household bills still to come, we may see CPI hit a fresh record in the coming months.

It looks like we could be seeing another interest rate hike before the summer is out.

Turning to the stock markets...

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email.

The markets also fell in continental Europe, with the Paris Cac-40 shedding 15 points to close at 4,734. The German Dax-30 was off 20 points at 5,396.

Across the Atlantic, US stocks managed to close higher as solid earnings reports from United Technologies and Coca-Cola offset some concerning economic data. US producer price inflation was higher than expected, rising 0.5% in June. And housebuilders' confidence fell to a 15-year low in July, amid worries about rising interest rates. The Dow Jones Industrial Average gained 51 to close at 10,799, while the S&P 500 rose 2 points to 1,236. The tech-heavy Nasdaq was up 5 to 2,043.

In Asia, Japanese stocks made gains, with the Nikkei 225 closing 63 points higher at 14,500. But internet stocks fell after Yahoo in the US reported a fall in profits.

Oil prices rose in New York this morning, with crude trading at around $74 a barrel. Brent crude was little changed, at around $74.50.

Meanwhile, spot gold fell back to around $626 an ounce as investors wait for today's congressional testimony from Federal Reserve chairman Ben Bernanke to see if US interest rates are likely to rise again in August. Silver was also lower, trading at around $10.50 an ounce.

And in the UK this morning, shares in property website Rightmove have dived after the Government U-turned on Home Information Packs, announcing that a key component, the housing condition report, would be voluntary for the foreseeable future. Rightmove and many other estate agencies have sunk large amounts of money into gearing up for the introduction of the packs next year.

And our two recommended articles for today...

Why you should invest in Japan

- Just when it seemed as though the Japanese recovery was under way, the market was hit particularly hard by May and June's stockmarket slump. But its revival is no false dawn. In fact, Japan could be the market most able to weather a global economic slowdown. To find out why it's the best stock market to buy into right now, see: Why you should invest in Japan

Will China drive UK prices up - or pull wages down?

- Inflation in the West has been kept down in recent years by the supply of cheap goods and services from China and India, say Andrew Selsby and John Robson in the Onassis newsletter. But what will happen when China revalues its currency? Will a stronger yuan export inflation to the rest of the world? Or is the greatest threat to the West actually that of wage deflation? Click here to find out what they believe: Will China drive UK prices up - or pull wages down?

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.