UK Faces Unimaginably Cruel Two Years, BoE Forecasts Suggest

The Bank of England on Thursday hiked rates by 75bps. It was a landmark moment. The three-quarter point move counted as the largest in 33 years.

It could’ve been even larger. During the height of the Truss mini-budget panic, markets briefly worried the BoE might need to resort to EM-style hikes in order to i) offset the risk of entrenched inflation from Liz Truss’s growth plan (recall that although the energy guarantee trimmed the near-term left tail inflation risk, it increased the odds of persistently elevated inflation over the medium- and longer-term) and ii) protect the pound, which hit a record low following the budget unveil.

Things have calmed down considerably since Truss’s unceremonious exit after just six weeks as prime minister, but to say Rishi Sunak has a tough task ahead of him would be to materially understate the case. Inflation in the UK is running rampant, and a recession is assured. I suppose I need to add the caveat that nothing is completely assured, but a protracted downturn in the UK is as close to a foregone conclusion as macro outcomes get.

Obviously, the BoE’s rapid hikes (figure below) will serve to compound the growth drag, as will any “austerity-lite” from the Sunak government.

The UK is stuck. It’s obvious after last month that the market isn’t going to countenance fiscal profligacy, and a BoE that comes across as insufficiently attentive to double-digit inflation is a BoE that risks a weaker currency and thereby more pass-through. So, stagflation it is.

Thursday’s vote was 7-2. The dissents were for 50bps and 25bps. I’m fairly confident that 25bps would’ve been a bad idea, even if hindsight eventually suggests the BoE overdid it in the run-up to recession. The consequences for the pound of an underwhelming move on Thursday would’ve been dire, especially when considered with the very dovish terminal rate guidance.

“Since the MPC’s previous forecast, there have been significant developments in fiscal policy,” the bank said. It was a laughable, but unavoidable, understatement. The bank referenced Jeremy Hunt’s updated fiscal plan, which tossed out Truss’s tax cuts, but kept the energy guarantee, albeit on a truncated timeline.

“The MPC’s working assumption is that some fiscal support continues beyond the current six-month period of the Energy Price Guarantee, generating a stylized path for household energy prices over the next two years,” the bank said, adding that although “such support would mechanically limit further increases in the energy component of CPI inflation… in boosting aggregate private demand relative to the August projections, the support could augment inflationary pressures in non-energy goods and services.”

That’s a polite way of saying that the price cap could lead to higher inflation for longer, even as it’ll prevent households from going bankrupt in the near-term. The bank now sees inflation peaking at 11% in the fourth quarter, down from ~13% (figure below).

Apparently, the UK will risk outright deflation in early 2026. The new projections suggest price growth will flatline in Q4 of 2025.

The new economic forecasts, conditioned on current rate expectations, show an eight-quarter recession (figure below). “GDP is projected to continue to fall throughout 2023 and 2024 H1, as high energy prices and materially tighter financial conditions weigh on spending,” the bank said.

The unemployment rate is expected to rise almost three full percentage points under the same assumptions, from 3.5% to 6.4% by the end of the forecast horizon. I’d note that it’s still seen rising in Q4 of 2025, which suggests there’s “no end in sight,” as it were.

“Although there is judged to be a significant margin of excess demand currently, continued weakness in spending is likely to lead to an increasing amount of economic slack emerging from the first half of next year, including a rising jobless rate,” the BoE remarked. “The unemployment rate is expected to rise to just under 6.5% by the end of the forecast period and aggregate slack increases to 3% of potential GDP.”

The BoE tried to guide lower than the market on the terminal rate. Indeed, they were explicit about it. “The majority of the Committee judges that, should the economy evolve broadly in line with the latest projections, further increases in Bank Rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets.”

That language suggested some voters might not be on board with any additional hikes, and that regardless, the consensus on the Committee is nowhere near market pricing for Bank Rate’s ultimate destination.

“The BoE comments re: the market-implied rate path obviously echo Ben Broadbent’s remarks from the other week,” Bloomberg’s Cameron Crise wrote. “That they were repeated after a more than 50bps rally in June Sonia futures is notable, and really provide a jarring contrast to the messaging from the Fed.”

“Andrew Bailey was very forthright in his press conference that rates are unlikely to rise as far as markets expect,” ING’s James Smith remarked. “The choice the Bank faces at coming meetings is one of hiking aggressively to protect sterling, or moving more cautiously to allow mortgage rates to gradually fall,” he added. “With around a third of UK mortgages fixed for just two years, we suspect the latter option will increasingly be seen as more palatable.”

Active gilt sales began this week, on a delay to account for last month’s turmoil, which necessitated “temporary” emergency bond-buying. Active sales of corporate bonds were restarted late last month after being halted to account for market conditions.

“Monetary policy had already been restrictive in light of falling real incomes, with the economy now likely to be entering recession,” the 25bps dissenting vote at this month’s meeting noted. “Importantly, most of the tightening in policy over the past year was yet to feed through to the real economy.”