Will inflation force interest rates and mortgage costs even higher?

New inflation data could be about to change interest rate expectations and have a serious impact on consumer spending. Our City writer assesses latest thinking.

Homeowners caught in the grips of spiralling mortgage costs are unlikely to get much respite tomorrow as new figures are due to show an inflation rate still well above 8%.

The slow pace of the UK’s unwinding of elevated price pressures means that financial markets have been pricing in the need for interest rates to go as high as 5.75%.

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The Bank of England’s latest policy decision is due on Thursday, when the expected quarter point increase will be the 13th consecutive hike in a run that would mean monetary policy well into restrictive territory at 4.75%.

There’s still a chance that the Bank will go for a 0.5% increase, particularly if tomorrow’s inflation reading for May delivers an upside shock. The annual rate in April stood at 8.7% and is only expected to fall back to 8.4%, reflecting core inflation at an unchanged 6.8% and the continued pressure from rising wages.

Capital Economics predicts CPI inflation will fall to the 2% target by the first half of 2024 and the core rate by early 2025, but only if the Bank triggers a recession in order to loosen the labour market and bear down on price and wage expectations.

To do this, it believes that the Bank will need to raise rates to a peak of 5.25% and keep them there until later in 2024. Such an approach would be in sharp contrast to the US, where the Federal Reserve is likely to be near the peak of its rate rise cycle after inflation fell to 4%.

The consultancy expects a UK recession to start later than it had previously thought in the second half of this year, with a peak-to-trough fall in real GDP of 0.5% rather than 1%.

The uncertainty over how far the Bank will hike rates yesterday led to short-dated government borrowing costs above 5% for the first time in 15 years.

This benchmark has driven the average rate on a two-year fixed home loan over 6%, adding significantly to typical repayment costs and sparking fears over the knock-on effect for future levels of consumer spending.

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UBS expects the Bank of England to hike interest rates by 0.25% tomorrow as well as in August, but regards the current market pricing for a peak rate of 5.75% as excessive.

The City firm said: “While we acknowledge the challenging inflation outlook in the UK (and globally), we see indications that wage and price pressures could start to ease gradually.

“The BoE itself has repeatedly argued that the impact of past rate hikes is yet to hit the economy. Against this backdrop, we currently attach a relatively low probability to a scenario in which the BoE extends its hiking cycle beyond September.”

As well as the policy decision, economists will have the latest growth and inflation projections and forward guidance from the Bank’s Monetary Policy Committee (MPC).