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Why Britain’s inflation nightmare may not be over

Higher taxes, big spending and handouts to workers risk triggering another wave of price rises

Rachel Reeves’s record tax-raising Budget will be bad news for homeowners with mortgages, according to the Bank of England.
Threadneedle Street has warned that interest rates are expected to fall more slowly because of Reeves’s inflationary Budget, keeping mortgage repayments higher for longer.
Rising costs for employers and a big rise in government spending means inflation will now take a year longer to fall back to the Bank’s 2pc target than previously forecast, it said. That will force the central bank to keep interest rates higher for longer.
The warning came as lenders raised mortgage rates even as the Bank of England cut the base rate. Virgin Money and Halifax increased their fixed-rate deals by as much as 0.25pc, just as the Bank’s rate-setters voted to cut the headline interest rate from 5pc to 4.75pc.
It may be a sign of what is to come.
Inflation has tumbled from its peak of 11.1pc all the way back to the 2pc target. Yet the Monetary Policy Committee (MPC), which Bank of England Governor Andrew Bailey chairs, is cutting interest rates painfully slowly, leaving borrowing costs well above where they were pre-pandemic.
Officials are concerned that inflationary forces in the economy have not been fully vanquished yet. Unfortunately for borrowers, Reeves’s Budget has stoked these concerns.
Big spending, borrowing, and taxation decisions taken by the Chancellor all threaten to change the terms of the MPC’s discussion.
It strengthens the case made by arch-hawk Catherine Mann, the one member of the MPC who voted to hold rates at 5pc this month, that rates must come down more slowly than many mortgage holders would like to ensure inflation is quashed.
Reeves’s policies raise the risk of “structural shifts in wage and price-setting behaviour”, a key concern of the MPC, which could keep inflation higher than it is comfortable with.
The Bank warned that the “combined effect” of the increase in employer National Insurance contributions and a sharp rise in the minimum wage were “likely to increase the overall costs of employment”. Companies may choose to pass this on to customers in the form of higher prices.
The Bank suggested there were already “some signs” that this scenario was materialising, with “services inflation remaining elevated”.
The Bank added: “The impact of the Budget announcements on inflation will depend on the degree to and speed with which these higher costs pass through into prices, profit margins, wages and employment.”
These are the key risks to inflation from the Budget.
Reeves was proud to announce another big rise in the National Living Wage in the Budget following this year’s near-10pc jump. The Chancellor confirmed a 6.7pc increase to come in April. The National Minimum Wage, which is paid to 18 to 20-year-olds, will meanwhile rise by 16.3pc to £10 an hour.
Welcome as this is to workers on the legal minimum, it also adds to pressure on companies’ costs.
The impact is magnified by the fact that many businesses must raise pay across the board to ensure they remain competitive. A supermarket manager does not want to see their pay premium over an entry-level shop floor worker eroded, for example. If they are paid £13 an hour and the National Living Wage rises to £12.21 an hour, as it will next year, they may well ask for a raise.
Some businesses surveyed by the Bank’s agents “report that they are coming under pressure to maintain pay differentials between scales”, the Bank of England’s Monetary Policy Report says.
Surveys of company bosses suggest pay rises will slow a little more next year, then stabilise at still high levels – between around 4pc and 5pc – which is worryingly strong for future inflation.
Then there is public sector pay. Reeves has agreed inflation-busting pay deals with doctors, teachers and train drivers. The Bank believes such deals will increase average weekly earnings across the country by half a percent, given the scale of the public sector.
The fear is that the pace of wage growth remains too fast to be consistent with inflation at 2pc.
The Chancellor’s raid on National Insurance contributions paid by employers was a shock to any bosses who thought Labour’s manifesto promise to freeze National Insurance would apply to them.
The headline rate rose from 13.8pc to 15pc and the earnings threshold at which it kicks in was lowered. The policy adds a major extra cost to hiring workers and is forecast to raise as much as £25bn for the Exchequer.
The MPC said the change fuelled “significant uncertainty around the labour market outlook and on inflationary persistence”.
This is not the only extra cost being piled on to businesses. Companies also face the cost of complying with enhanced workers’ rights, which bosses have warned adds to the risk and expense of taking on more staff.
The Government is also spending heavily, particularly in the next two years. While this will provide a short-term boost to growth, competition for resources means it will also fuel price rises.
Alongside an initial sugar rush of economic growth, the Bank of England estimates that the Budget adds as much as 0.4 percentage points to inflation in the coming years, keeping price rises above target.
Instead of falling sustainably below the 2pc goal in 2026, as was forecast in August, CPI will remain above that level until early 2027.
Even at the end of the three-year forecast, the Budget leaves inflation around 0.3 percentage points higher than it would otherwise have been.
What matters now is how companies handle the extra costs piled on them by the Budget. While there is no doubt government spending will add to inflationary pressures, what is less clear is how much businesses could fuel price rises.
Employers have a choice: absorb the increased costs themselves, pass it on to staff through lower wage increases, or pass it on to customers through higher prices. It is the third option that will most worry the Bank of England and could keep interest rates – and therefore mortgage costs – higher for longer.
Legally speaking, the increase in employment costs through National Insurance changes and other burdens is a charge on companies, not their workers.
But the Office for Budget Responsibility estimates that around three-quarters of the cost will be paid by workers in the form of lower pay rises, with only one-quarter falling on businesses.
The Bank of England is not so certain this will be the end result – it suspects a slightly smaller share will be paid by staff.
As for price rises, several bosses have already warned they are looking at this lever. Sir Tim Martin, the chief executive pub group JD Wetherspoon, has said the price of a pint will rise, while Marks & Spencer has said it “can’t rule out” higher prices.
Ultimately, the path for inflation will “depend on the degree to and speed with which those costs would be transmitted into prices, wages, employment, or otherwise absorbed in profit margins or productivity growth”, the MPC says.
It is this uncertainty that risks keeping interest rates higher for longer – and it all stems from the Budget. Mortgage-holders will not be thanking Reeves.

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