Wednesday, May 31, 2023

BoE insists it is still winning the fight to control inflation

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The past three months have not been kind to monetary policymakers at the Bank of England.

In February, the central bank set interest rates at 4 per cent and suggested this level might well be the peak because its forecasts had inflation falling sharply, dropping below the central bank’s 2 per cent target at the start of 2024.

Three months on, and the BoE raised interest rates on Thursday by a quarter of a percentage point to 4.5 per cent, and predicted inflation will be more than double its target early next year.

It estimated close to a 50 per cent probability of inflation remaining above 2 per cent by mid-2026. That would leave the BoE Monetary Policy Committee with a record of above-target price rises for five consecutive years.

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The latest central bank inflation forecast meant governor Andrew Bailey faced hostile questions from the media after the latest interest rate decision.

Accepting that higher interest rates were a bitter pill for households struggling with the cost of living crisis, he insisted it was the right medicine to take. “If we don’t tackle inflation, it will be worse for people,” said Bailey.

He was asked by journalists whether the BoE had any credibility fighting inflation given its record, and what policy mistakes it had made.

Bailey reiterated the MPC’s determination to push consumer price inflation down from 10.1 per cent in March to its 2 per cent target.

But when it came to the speed at which inflation should fall, the governor said a “debate” was happening within the MPC, adding that he thought “the path we’ve got is not unreasonable”.

Bailey said financial markets showed little sign yet that the BoE had lost credibility, and that households expected the central bank to succeed in taming inflation.

The governor also criticised “the language of blame” in relation to the MPC’s actions, saying the Covid pandemic and the war in Ukraine were events that had pushed up inflation and which the BoE could not have anticipated.

Bailey appears correct in asserting that financial markets have not lost confidence in the BoE, but traders do not think inflation will drop without further rate rises. They are expecting the BoE will raise the cost of borrowing close to 5 per cent in two more increases.

Bailey did nothing to push back against this, saying “we are not giving a directional steer on rates today”.

Most economists took the BoE’s higher inflation forecast and lack of complaint at financial market expectations as a reason to believe the probability that the BoE would raise rates further was strong. That contrasts with the US Federal Reserve, which last week hinted it was ready to pause its rate rises.

Kallum Pickering, economist at Berenberg Bank, a private lender, said the BoE appeared to want to be “data-dependent with a hawkish bias”.

Martin Beck, economic adviser to the EY Item Club, a forecasting group, said “the hawkish skew of today’s announcement suggests one more rate rise may be in the offing”.

In its latest assessment of the UK economic outlook, the BoE dropped its previous prediction of a recession.

Line chart of UK real GDP (Q4 2019 = 100) showing The BoE now thinks the UK will avoid a recession

But the BoE accepted it had underestimated food price rises in its previous forecasts and that the pass-through of higher producer costs to consumer prices may take time.

“This could result in food inflation remaining higher for longer than suggested by developments in input costs alone,” the BoE warned in its monetary policy report.

That was the main reason for the increase in the inflation forecast over the coming year, said BoE officials.

In 2024, higher inflation would come from more robust corporate and household spending than previously expected, the central bank said, which would exceed the additional capacity for the economy to grow that stemmed from lower energy prices.

The boost to demand, the BoE reckoned, came from improved business and consumer confidence alongside the March Budget’s childcare subsidies and increase in corporate tax reliefs for investment.

The MPC said this improved outlook increased the risk of reinforcing the so-called wage price spiral, in which workers demand pay rises to match higher living costs and companies raise prices to protect their profit margins in a repeating, self-fulfilling process.

The seven people on the nine-member MPC who voted for the rate rise highlighted their nervousness about inflation in the minutes published alongside the decision.

They said “there remained a risk that the . . . effects of external cost shocks on inflation in wages and domestic prices could take longer to unwind than they had to emerge”.

Line chart of UK unemployment rate (%)  showing Unemployment is expected to rise less steeply than previously thought

Meanwhile, Bailey criticised BoE chief economist Huw Pill’s “choice of words” after he said last month that UK companies and households needed “to accept that they’re worse off and stop trying to maintain their real spending power”.

However, the governor endorsed the sentiment behind Pill’s words, and the BoE is seeking to raise unemployment and lower corporate and household spending power through higher interest rates to create enough pain to halt the wage price spiral.

The big question is whether the BoE has done enough to bring inflation under control, given the central bank no longer expects a recession and thinks unemployment will rise only from 3.8 per cent to 4.5 per cent.

Most of those who watch the BoE closely believe it has not, and therefore will raise rates by at least another quarter of a percentage point before it pauses for breath.



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