Quantitative Easing

Bank of England shocks with extremely bleak outlook

The Bank of England on Thursday kept its promise to act “forcefully” to curb soaring inflation, announcing the biggest hike in interest rates in more than a quarter of a century.

But while the rise in borrowing costs was no more than analysts had expected, the central bank‘s extremely gloomy view of the immediate economic outlook came as a shock.

BoE policymakers have accelerated the pace of monetary tightening despite predictions of a recession that is expected to match that of the early 1990s and the biggest decline in household incomes in more than 60 years.

BoE Governor Andrew Bailey argued that this painful pressure on living standards was now unavoidable and necessary to bring inflation under control and avoid a more severe economic downturn later.

“Inflation hits the less well-off the hardest. If we don’t act now. . . consequences later will be worse,” he told a news conference after the BoE’s Monetary Policy Committee decided to raise interest rates by 0.5 percentage points to 1, 75%.

He added that despite the “very uncomfortable position” policymakers found themselves in, “there is no if and no but in our commitment to the 2% inflation target.” Consumer price inflation hit a new 40-year high of 9.4% in June.

The sharp downward revisions to the BoE’s growth forecasts are almost entirely due to the renewed spike in wholesale gas prices resulting from tight supplies from Russia. Analysts said it could hit Britain’s economy harder than others in Europe, where governments have done more to protect consumers.

The BoE estimates the annual fuel bill for a typical UK household could now rise from just under £2,000 to around £3,500 when regulators reset their price cap in October – driving up price inflation consumption above 13% by the end of the year and maintaining it in double digits for much of 2023.

“The immediate outlook for inflation is now so dire that the Monetary Policy Committee feels it has no choice but to cause a more severe economic downturn,” said Ross Walker, economist at NatWest Markets, qualifying that of “sobering policy change”.

Line chart of UK CPI inflation (%), with BoE forecast of double-digit inflation expected to last a year

But this short-term inflation spike is not the main concern of policymakers, despite criticism of the BoE from some Tory MPs for not acting sooner to curb rising prices.

Policymakers said the surge in inflation was largely due to global pressures already easing, with commodity prices falling slightly and supply chains starting to run more smoothly.

BoE Deputy Governor Ben Broadbent said the central bank could not have foreseen the war in Ukraine and could not have countered its effects realistically, even with “extraordinary insight”, given the magnitude of the response needed to offset such an unprecedented set of shocks. .

The MPC’s biggest concern is that inflation will remain above the BoE’s 2% target once these global pressures ease, if businesses and households get used to rapidly rising prices and change their behavior accordingly.

“We’ve seen things that concern us, frankly,” Bailey said, pointing to survey evidence that wage growth had accelerated since May, amid continued labor shortages, while businesses were still confident of passing on rising costs to consumers.

Full-year forecast bar chart (%) showing that the UK's growth and inflation outlook compares poorly to the rest of the G7

But the BoE believes the looming recession will soon take the heat out of the labor market, with unemployment expected to rise from the middle of next year and top 6% by mid-2025.

The central bank’s forecast suggests that inflation could fall below its 2% target by the end of 2024, even if energy prices remain high for longer than markets currently expect and if the BoE takes no further policy action, with interest rates steady at the new level of 1.75 percent.

Bailey said the uncertainty surrounding this forecast was exceptionally high, particularly regarding energy prices, and made it clear that the BoE’s aggressive action on Thursday should not be taken as a signal that she would now embark on a predetermined series of rapid increases. rate increases.

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

One of the actions the BoE plans to take in September is to start monthly selling the £875bn of assets it has built up under its quantitative easing programs – with regular disposals aimed at reducing the stockpile of assets. around £80bn in the first 12 months. But the BoE made it clear that interest rates would remain its main tool for adjusting monetary policy.

Chart showing how the forecast UK recession compares to previous downturns - Cumulative % change in GDP from pre-recession peak

Analysts said BoE forecasts suggested interest rates may need to fall in the longer term, although the MPC deemed it necessary to tighten policy further in the near term to keep inflation under control.

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

But Sandra Horsfield, an economist at Investec, noted that the BoE’s forecast did not take into account any of the fiscal stimulus offered by the two Conservative leadership candidates – and that tax cuts or other policy choices could affect the outlook “significantly”.