The Bank of England painted two pictures of the outlook for the UK economy on Thursday. Both scenarios were bleak.
Whatever happened, the central bank said, the British economy was slipping into a recession that would last at least all of next year. Unlike the Federal Reserve, which on Wednesday still hoped for a “soft landing” for the US economy, the BoE’s talk was of falling gross domestic product and a “very challenging” outlook.
Andrew Bailey, the BoE governor, said this was inevitable because there were “important differences between what the UK and Europe faced in terms of shocks and what the US is experiencing”. Europe, unlike the US, has been grappling with skyrocketing gas prices following Russia’s invasion of Ukraine.
The BoE’s gloomy forecasts did not end with recession. Inflation would be above 10 percent for the next six months and above 5 percent for all of 2023. Unemployment, currently at a 50-year low of 3.5 percent, would end next year above 4 percent.
If all this pain was common to both BoE’s scenarios, the differences between them were key to the central bank’s messages.
In the first BoE scenario – normally seen as its headline forecast – forecasts were based on the assumption that financial markets’ expectations of future interest rates would see them peak at 5.25 per cent next year.
If interest rates were to peak at this level, the BoE’s Monetary Policy Committee said it was most likely that the UK would have to endure eight quarters of economic contraction: the longest recession since World War II. Unemployment would rise to 6.4 percent. This economic pain would weigh on inflation, bringing it to zero by the end of 2025.
But with the BoE targeting an inflation rate of 2 per cent, Mr Bailey was clear that this scenario suggested markets were at risk of miscalculating future monetary policy. “We believe [the] Bank rate will have to go up by less than what is currently priced in the financial markets, says Bailey.
The BoE’s alternative scenario – normally buried in the central bank’s forecast document – of interest rates remaining constant at the current level of 3 per cent was given much more prominence in presentations by Bailey and his team.
According to this prediction, output would still shrink, but only by half as much as in the first scenario, resulting in a mild recession by historical standards. Inflation would fall to 2.2 percent over two years before falling below the BoE’s target. Unemployment would rise, but only to 5.1 percent.
Many economists said the BoE’s alternative scenario was a clear signal from the central bank that interest rate hikes were close, having raised them from 0.1 percent a year ago to 3 percent, the highest level since 2008.
Kallum Pickering, an economist at Berenberg, said the recession in the BoE’s first scenario meant the central bank “may have to do much, much less than the market expects in terms of further rate hikes to bring inflation back to its 2 percent target”.
Asked which of its two scenarios the BoE thought was more likely, Bailey would not be drawn. He would not commit to a specific view on future rates, saying: “Where the truth is between the two, we don’t give guidance on that.”
His main reason for refusing to be more specific is the possibility that inflation is proving more entrenched than the BoE currently believes.
Bailey said that while no prediction would ever be exactly right, the biggest risk was that inflation would still be higher than the central forecasts in both BoE scenarios.
A key danger for the BoE is that wage growth could easily stay higher than it would like, with firms feeling able to raise prices without losing too much business.
Ruth Gregory, economist at Capital Economics, said the BoE’s multiple upward revisions to market expectations of future interest rates over the past year suggested inflation could prove “stickier” than hoped.
By the end of the day, markets had little notice of the BoE’s dovish scenario. Ahead of the BoE’s midday announcement, markets were pricing in rates peaking at 4.75 percent next year. By the end of the day, they were betting that they would peak at 4.72 percent next September.
Market expectations for future monetary policy will move, and Bailey was keen to highlight what would guide BoE decisions in the coming weeks.
Most important, he said, would be the development of economic data, particularly on wages and corporate pricing strategies. If these soften, the BoE would feel less need to raise interest rates further.
The path of wholesale energy prices would also be crucial, and the BoE will be hoping these moderate further and have more than halved since late August.
The other deciding factor will be Chancellor Jeremy Hunt’s Autumn Statement on 17 November. If the government goes ahead with immediate government spending cuts and tax hikes to plug a gap in public finances, it will squeeze the economy further and ease pressure on the BoE to raise interest rates.
Ben Broadbent, the BoE’s deputy governor, suggested that any fiscal action by the government would need to take place “in the relatively short term” to influence the central bank’s interest rate decision.
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