The Bank of England celebrated 25 years of independence by hiking rates 25bps on Thursday.
It was the fourth consecutive hike and brought Bank Rate to the highest of the post-financial crisis era (figure below). The vote was 6-3, with the dissenters favoring a 50bps move.
The new statement echoed the Fed in citing the combination of the war in Ukraine and lockdowns in China as factors that could prolong supply disruptions, weigh on growth and exacerbate inflation.
“Global inflationary pressures have intensified sharply following Russia’s invasion of Ukraine [leading] to a material deterioration in the outlook for world and UK growth,” the MPC said, adding that “these developments have exacerbated greatly the combination of adverse supply shocks that the UK and other countries continue to face [while] concerns about further supply chain disruption have also risen, both due to Russia’s invasion and to COVID-19 developments in China.”
Suffice to say that isn’t a particularly upbeat assessment. The new projections showed the BoE now expects inflation to exceed 10% on average during the fourth quarter.
“The majority of [the] further increase [versus Q2] reflects higher household energy prices following the large rise in the Ofgem price cap in April and projected additional large increase in October,” the MPC explained, noting that “the price cap mechanism means it takes some time for increases in wholesale gas and electricity prices, and their respective futures curves, to be reflected in retail energy prices.” That, in turn, means inflation in the UK will peak later than other advanced economies.
Of course, it’s not just energy. “The expected rise in CPI inflation also reflects higher food, core goods and services prices,” the BoE said. So, prices for everything, basically. As the figure (below) shows, the bank still expects inflation to eventually recede to 2% — sometime around 2025.
You can write your own tragic jokes. I’ll lean on the same language I’ve used over the past four MPC meetings. Despite being spectacularly wrong so far, the BoE expects the public to trust a new set of forecasts which claim for the Committee the kind of supernatural prescience one would need in order to project a macro variable three years into the future.
Note that household energy prices rose more than 50% last month and are expected to increase another 40% in October. Between them, goods and energy prices should account for around four fifths of the inflation overshoot.
Recall that 25% of the UK’s inflation basket is experiencing double-digit increases. That figure rises to 50% if you lower the threshold to increases of at least 5%. In its March economic and fiscal outlook, the Office for Budget Responsibility said real household disposable income per person will drop by 2.2% in 2022-23, the biggest decline in any single financial year since ONS records began in 1956-57 (figure below).
Plainly, that doesn’t bode well for consumption. Retail sales dropped three times more than expected in March. In April, a measure of consumer confidence plunged to the worst levels since the financial crisis.
This conjuncture is conducive to stagflation. And, indeed, the BoE expects UK GDP to fall in the fourth quarter “driven largely by the decline in households’ real incomes” on the heels of the October Ofgem price cap reset. In 2023, annual GDP will contract, the bank suggested.
Stagflation is now the base case. Officials likely wouldn’t put it that way, but I don’t see much utility in scouring the thesaurus for euphemisms.
The bank’s new projections are conditioned on a market-implied path for policy rates rising to 2.5% by mid-2023, and falling to 2% by the end of the forecast period.
Note that inflation is seen undershooting the bank’s target by a mile in Q2 2025 assuming the market-implied trajectory for rates. That’s problematic. The combination of a projected economic contraction and a large inflation undershoot (even if it’s in the out year forecast) suggests the market is wrong on the likely path for rates, the BoE is on the brink of a policy mistake or, most likely, both.
Conditioned on rates staying at current levels, inflation would be right around target three years from now (figure above).
The meeting minutes acknowledged the implied quandary, noting that “on the market path for Bank Rate, the endpoint of the forecast was characterized by a large margin of excess supply and CPI inflation well below target.” Nevertheless, “most” members said “some” additional tightening would likely be warranted over the “coming months.”
As for the dissenters, they suggested policy “should lean strongly against risks that recent trends in pay growth, firms’ pricing strategies and inflation expectations in the economy more widely would become more firmly embedded.” More aggressive tightening now, they argued, would “reduce risks of a more extended and costly tightening cycle later.”
Thursday’s decision also included a nod to active selling of UK government bonds purchased under the bank’s QE program. “The Committee reaffirms that the decision to commence sales will depend on economic circumstances including market conditions at the time, and that sales would be expected to be conducted in a gradual and predictable manner so as not to disrupt the functioning of financial markets,” the statement said.
Apparently, a “strategy” for sales will be unveiled in August. The BoE would become the first major central bank to attempt active sales (as opposed to passive runoff) of government bonds held on its balance sheet. Corporate bond sales will commence in September.
This was, in no uncertain terms, a total debacle. The MPC is plainly divided on the proper course of policy, inflation is seen hitting double-digits later this year, stagflation is now the base case (at least for Q4) and if the market is right on where rates will ultimately end up, the UK may find itself staring at disinflation within three years.
At his press conference Thursday, Andrew Bailey said he “recognize[s] the hardship” people in the UK are about to face. The BoE is “particularly” concerned, he suggested, about “those on lower incomes.”