BoE prepares ground for long inflation battle
Markets may be underestimating the economic costs of restoring price stability.
The Bank of England’s (BoE) monetary policy committee (MPC) decided to keep interest rates on hold at 5.25% at the November meeting in line with expectations. However, the main message from the MPC was for households and companies to prepare for a prolonged period of high interest rates.
Despite the obvious weakness in the economy’s current performance, inflation remains far too high. The BoE forecasts the consumer price index (CPI) inflation rate to drop towards 5% by the end of the year, before falling back towards target in two years' time and beyond.
Most of the fall in the near term is expected to be driven by declining household energy bills, along with moderating food price inflation. However, the outlook for 2024 is more difficult, and requires spare capacity in the economy to lower both goods price inflation and services inflation.
Services inflation has been driven higher by wage inflation – a response to strong demand and a lack of availability of staff. The BoE points out that the dynamics in the labour market have been cooling, helping to raise the unemployment rate and offer greater slack. However, as wage inflation has remained high, the BoE now believes that the non-accelerating inflation rate of unemployment (NAIRU) has risen.
This suggests that the unemployment rate may need to be higher in order to calm wage inflation.
The latest quarterly Monetary Policy Report (MPR) published alongside today’s decision includes two sets of forecasts for the economy. The first is predicated on the market’s pricing of interest rates, and the second is based on interest rates being held at the current level of 5.25% for the whole three-year forecast period. The first forecast has interest rates falling from the fourth quarter of next year, but only to 4.50% by the end of 2025.
Based on this profile, the MPC judges that CPI inflation would most probably decline to 1.9% in two years’ time (modal forecast), and therefore below the BoE’s inflation target. However, when taking all risks into account and looking at an average of scenarios (mean forecast), inflation would only fall to 2.2%. This suggests that some cuts could be on the horizon, but they are vulnerable to additional shocks.
The MPC’s second approach of using constant rates has inflation falling slightly more, but again, it’s a close call when all risks are considered.
Interestingly, financial markets have become even more dovish than at the time the BoE took the above-mentioned market interest rates profile. Markets currently (post decision and publication of the MPR) have two rate cuts priced in for next year. This suggests that investors are not convinced that the BoE will be able to keep interest rates that high for such a length of time.
Ultimately, even through the MPC’s forecast suggests it will be more hawkish that markets expect, its language in the published minutes leave a lot of wiggle room. It states that “…monetary policy would need to remain restrictive for an extended period of time”.
Nobody is likely to argue that interest rates at, say, even 4% would be considered to be “loose”. We suspect that once inflation falls towards the Bank’s upper limit of 3%, interest rates will start to fall faster.