Bank of England serves up a shock with its intensely gloomy outlook

The Bank of England on Thursday delivered on its promise to act “forcefully” to curb rising inflation by announcing the largest rise 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 intensely gloomy view of the immediate economic outlook came as a shock.

BoE policymakers have accelerated the pace of monetary tightening, despite forecasting a recession similar to that seen in the early 1990s and the largest decline in household income in more than 60 years.

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

“Inflation hits the least fortunate the hardest. If we don’t do anything now. . . the consequences will be worse later,” he said at a news conference following the BoE Monetary Policy Committee’s decision to raise interest rates by 0.5 percentage points to 1.75 percent.

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

Major cuts in the BoE’s growth forecasts are almost entirely due to the renewed rise in wholesale gas prices due to Russia’s supply constraints. 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, pushing consumer price inflation above 13 percent by the end of the year and it remains within limits. double digits for much of 2023.

“The immediate inflation outlook is now so dire that the Monetary Policy Committee believes it has no choice but to bring about a more severe economic downturn,” said Ross Walker, an economist at NatWest Markets, calling it a “deeply sobering policy change.”

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

But this rapid rise in inflation is not the main concern of policymakers – despite criticism of the BoE by some Conservative MPs for not taking action earlier to curb price increases.

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

Ben Broadbent, deputy governor of the BoE, said the central bank could not have foreseen the war in Ukraine or realistically countered its consequences, even with “extraordinary insight” given the magnitude of the response needed to to compensate for such an unprecedented series of shocks. .

The MPC’s main concern is that inflation will remain above the BoE’s 2 percent target once these global pressures ease, as businesses and households get used to prices rising rapidly and their behavior changes as a result.

“Frankly, we’ve seen things that worry us,” Bailey said, pointing to research data showing that wage growth has accelerated since May, amid ongoing labor shortages, while companies were still confident in increasing costs by pushing through higher costs. charge to consumers.

Bar chart of full-year forecasts (%) showing that the UK's growth and inflation outlook compares poorly with the rest of the G7

But the BoE thinks the looming recession will quickly wipe out the job market, with unemployment rising from mid-next year and reaching more than 6 percent by mid-2025.

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

Bailey said the uncertainty surrounding these forecasts was exceptionally high, especially when it came to energy prices, and made it clear that the BoE’s aggressive move on Thursday should not be taken as a signal that it would now embark on a pre-determined series of rapids. rate rises.

“Policy is not on a predetermined path, and what we’re doing this time doesn’t tell you what we’re going to do next time,” he said. “All options are on the table at our meeting in September and beyond.”

One move the BoE plans to take in September is to begin monthly sales of the £875 billion in assets accumulated under its quantitative easing programs — with steady sales aimed at reducing inventory by about £80 billion in the first 12 months. But the BoE made it clear that interest rates would remain the main tool for adjusting monetary policy.

Chart showing how the forecasted recession in the UK compares to past recessions - cumulative change in % of GDP since the pre-recession peak

Analysts said the BoE’s forecasts suggested that longer-term interest rates may need to fall, even if the MPC deemed it necessary to further tighten policy in the near term to bring inflation under control.

“Overall, the bank is forecasting stagflation and suggesting that in the near term the drug is the hard love for higher interest rates and that further down the line the comfort blanket of rate cuts may be needed,” said Paul Dales of the consulting firm Capital Economics.

But Sandra Horsfield, an economist at Investec, noted that the BoE’s forecasts failed to take into account the fiscal stimulus proposed by both candidates for conservative party leadership — and that tax cuts or other political choices could “make the outlook material.” to influence.

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