Bank of England shows new focus on inflation

The Bank of England (BoE) has raised its main policy interest rates from 1.25% to 1.75% - a rise of 50 basis points (bps) and an acceleration in the pace of tightening compared to recent meetings.

The BoE raised its forecast for Consumer Prices Inflation (CPI) to show a peak of around 13% year-on-year (y/y) later in 2022.

But the Bank also slashed its GDP growth forecast from -0.2% to -1.4% for 2023, as it now expects the economy to experience a significant recession.

A hawkish tone, for now...

In the press conference which followed the publication of the quarterly Monetary Policy Report (MPR), the Bank’s governor Andrew Bailey emphasised that the Monetary Policy Committee (MPC) is solely focused on returning inflation to target.

This is a notable shift in tone from the governor who in the past had stressed the need for “…walking a tight line between tackling inflation and avoiding recession”.

The MPC has become increasingly concerned over inflation pressures becoming more persistent and broadening out beyond the initial energy and food price shocks seen in recent months. This was reflected in the MPR’s analysis and projections which is used by the committee to make its decisions.

The MPR warned that the labour market remains very tight, and that wages should continue to rise in the near-term, with companies suggesting that they expect to pass on costs to customers, raising inflation pressures. Indeed, we highlighted these risks recently, and warned that the Bank needed to step up monetary tightening, or else risk higher inflation for longer. (see A timid BoE will mean higher for longer UK inflation).

In addition to the larger rate rise this month, the BoE also announced that the MPC would take a vote at the September meeting to decide whether or not to start to actively sell its holdings of gilts, in order to shrink the size its balance sheet faster.

This is known as quantitative tightening (QT), or the reverse of the quantitative easing seen over the past decade. QT should reduce the amount of liquidity and in theory inflation pressures in the economy. If approved, the planned sales would commence from that point, and would help to reduce the size of the Bank’s balance sheet by £80 billion over the next 12 months.

... but a more dovish signal for markets?

Despite the obvious concerns over inflation in the near-term, the Bank’s forecast out to 2025 gave a far more dovish story. The recession included in the forecast lasts for seven quarters, with output falling 2.2% from peak to trough. This is expected to raise the unemployment rate to over 6% by 2025, as significant excess spare capacity in the economy appears.

This helps not only lower inflation back to 2% by the end of 2024, but crucially, is forecast to lower inflation to less than 1% by the middle of 2025. This would be below the lower limit of the symmetric range around the 2% target, calling in to question the assumptions used for the path of interest rates moving forward.

The BoE’s forecast is conditioned on the market pricing for interest rates, which at the time had rates rising to 3% in 2023, before falling back to 2.2% by 2025. Based on the forecast for inflation, there appears to be a signal to investors that they have assumed either too many rate rises, or not enough of a fall in rates at a latter point.

Indeed, using the Bank’s alternative forecast which has interest rates held at their current rate of 1.75%, inflation returns to target just a quarter later, and does not fall below 1% at the end of the forecast period. This suggests that the BoE could simply stop raising interest rates now.

The forecast has come across as very dovish to markets, causing sterling to fall around half a percentage point against the US dollar by the end of the press conference, and a little more against the euro.

Different messages for different audiences

There are two messages being communicated to two different audiences. A more dovish signal for sharp eyed investors that pay attention to the forecasts, but also a more hawkish tone with tighter policy to match for the public, press and politicians. The latter of which have become increasingly critical of the Bank’s performance in managing inflation of late.

The most asked question at the MPR press conference was in reaction to comments made by Liz Truss, the odds on favourite to replace Boris Johnson as prime minister, who oddly has drawn comparisons between the BoE and the Bank of Japan, along with suggesting that she would seek to reform the Bank’s mandate given the inflation outturn. Bailey refused to respond to the question, stating that it is inappropriate to comment on the leadership race, however, he could have done a better job defending the need for central bank independence which is potentially being threatened.

Looking ahead, the Bank is likely to keep raising interest rates even if it believes it has already done enough already. It may then be able to pause once inflation peaks, and the focus of the public turns towards the recessionary environment.

Inflation could remain a problem for longer than expected

Where we differ from the Bank in its assessment in that we do not believe that inflation will fall back by anywhere near as much as the BoE is forecasting. We see greater domestic inflationary pressures building, which will require even higher interest rates.

This is likely to stop the Bank cutting interest rates in 2023/24, as suggested by its forecast, but instead continue to maintain above neutral rates for longer, with the hope that inflation returns to target over a longer period of time.

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