The Bank of England offers a shock with its intensely bleak prospects

On Thursday, the Bank of England delivered on its promise to act “forcefully” to curb rising inflation, announcing the largest interest rate hike in over a quarter of a century.

But while the rise in borrowing costs was no more than analysts expected, the central bank’s intensely gloomy view of the immediate economic outlook was a shock.

BoE policymakers have accelerated the pace of monetary tightening despite the forecast of a recession set to match that of the early 1990s and the largest decline in household incomes in over 60 years.

Andrew Bailey, BoE Governor, said this painful squeeze in living standards was now inevitable and necessary to keep inflation in check and avoid a tougher economic downturn later on.

Line chart of real GDP (Q4 2019 = 100) showing the BoE's forecast for five quarters of recession

“Inflation hits the poorest hardest. If we don’t act now. . . the consequences later will be worse, “he said in a press conference following the decision by the BoE’s Monetary Policy Committee to raise interest rates by 0.5 percentage points to 1.75%.

He added that, despite the “very uncomfortable position” in which politicians have found themselves, “there are no ifs and buts in our commitment to the 2 percent inflation target.” Consumer price inflation hit a new 40-year high of 9.4% in June.

The major downgrades of the BoE’s growth forecasts are almost entirely due to the renewed surge in wholesale gas prices resulting from the restriction of supplies by Russia. Analysts said this could hit the UK economy harder than others in Europe, where governments have done more to protect consumers.

The BoE estimates that a typical British household’s annual fuel bill could now rise from just under £ 2,000 to around £ 3,500 when regulators reset their price cap in October, driving consumer price inflation beyond 13% by the end of the year and keeping it unchanged. double digit for much of 2023.

“The outlook for immediate inflation is now so dire that the Monetary Policy Committee feels it has no choice but to engineer a more severe economic downturn,” said Ross Walker, economist at NatWest Markets, calling it a “deeply troubling policy shift.” .

UK CPI inflation line chart (%), with BoE forecast showing double digit inflation expected to last one year

But this short-term rise in inflation is not the main concern of policymakers, despite criticism of the BoE by some Conservative MPs for failing to act earlier to curb price increases.

Policy makers said the spike in inflation is largely due to global pressures already easing, with commodity prices falling and supply chains starting to run more smoothly.

Ben Broadbent, BoE deputy governor, said the central bank could not have predicted the war in Ukraine and could not realistically counter its effects, even with “extraordinary insights”, given the scale of the response needed to offset a series of shocks. so unprecedented.

The MPC’s biggest concern is that inflation will remain above the BoE’s 2% target once these global pressures have eased, if businesses and households get used to the rapid rise in prices and consequently they will change their behavior.

“We’ve seen things that worry us, frankly,” Bailey said, pointing to evidence that wage growth had accelerated since May, amid continuing labor shortages, while companies were still confident of passing higher costs on to consumers. .

Full year forecast bar chart (%) showing UK growth and inflation outlook not comparable to the rest of the G7

But the BoE thinks the looming recession will soon take the heat out of the labor market, with unemployment set to rise by mid-next year and exceed 6% by mid-2025.

The central bank’s forecasts suggest that inflation could fall below the 2 percent target by the end of 2024, even if energy prices remain high for longer than markets currently expect and if BoE will not take further policy action, with interest rates steady at the new 1.75 percent level.

Bailey said the uncertainty around these predictions is exceptionally high, especially regarding energy prices, and made it clear that the BoE’s aggressive action on Thursday should not be taken as a signal that it will now embark on a series. predetermined of rapid the rate increases.

“Politics is not on a set course and what we do this time does not tell you what we will do next time,” he said. “All options are on the table at our September meeting and beyond.”

One step the BoE plans to take in September is to start monthly sales of the £ 875bn of assets accumulated under its quantitative easing programs, with steady disposals aimed at reducing shares by around £ 80bn in the top 12. months. But the BoE made it clear that interest rates would remain its main monetary policy adjustment tool.

Graph showing how UK recession forecast compares to previous downturns: cumulative percentage change in GDP since pre-recession peak

Analysts said the BoE’s forecasts suggest interest rates may need to fall in the longer term, even if the MPC deems it necessary to tighten policy further in the short term to keep inflation in check.

“Overall the bank is predicting stagflation and suggests that in the short term medicine is the tough love for higher interest rates and that the comfort blanket of interest rate cuts may be needed later on,” said Paul. Dales of the consulting firm Capital Economics.

But Sandra Horsfield, an economist at Investec, noted that the BoE’s forecasts do not take into account the fiscal stimulus proposed by both Conservative party leadership candidates and that tax cuts, or other policy choices, could affect the outlook “materially”. .

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