Interest rates have risen again in response to high inflation, but the economic trade-off is becoming more challenging.
Summary
The Bank of England’s Monetary Policy Committee (MPC) voted to raise interest rates again in May (by 25 basis points) to 1%. This was the fourth consecutive rise in interest rates, bringing them to their highest level since 2009.
However, by historical comparison, interest rates are still comparatively low.
All MPC members voted for a rate rise, but some wanted to go further – with three members (Jonathan Haskel, Catherine Mann and Michael Saunders) voting for a 50 basis point increase (to 1.25%). Overall, the Committee continues to be swayed by strong global inflationary pressure, and further signs of stronger domestic price pressures.
This was most starkly illustrated in the Bank’s latest forecasts. CPI inflation is expected to stay high this year, reaching a peak of over 10% in Q4 (the rate of inflation stood at 7% in March). The resulting squeeze on real incomes leads to a marked slowing in growth, though the Bank do not expect the economy to fall into a technical recession.
The high inflation/weak growth outlook highlights the trade-off that the MPC are facing in setting monetary policy – the Committee continued to flag that “some degree of tightening in monetary policy might still be appropriate in the coming months”.
Their forecasts offer some clue as to how many more rate rises we can expect. The BoE’s forecasts are conditioned on financial markets’ expectations for interest rates, which pencil in Bank rate reaching around 2.5% by the end of 2023 (implying six more 25 basis point hikes). However, on this basis, the Bank expect inflation to fall substantially below their 2% target in two years’ time – implying that rates rising to this level would be excessive.
Further monetary tightening will also come in the form of an unwinding of quantitative easing. In line with their earlier forward guidance, the BoE will now actively consider selling their holdings of government bonds, purchased as part of previous stimulus rounds. The Committee have asked Bank staff to work on a strategy for bond sales, and more details will be forthcoming at its August meeting.
While it’s clear we’ll see further monetary tightening ahead, the MPC is walking an increasingly fine line: between the need to curb inflation, and not choking off economic growth further.
This is true of central banks in most other advanced economies too. Notably, the US Federal Reserve also raised interest rates yesterday, at a much faster pace (50 basis points) than the BoE today.
MPC swayed by a strengthening in domestic price pressures
The key considerations underpinning the MPC’s decision to raise rates were:
- Strong momentum in the labour market
- Stronger-than-forecasted domestic inflationary pressures
- A strengthening in underlying wage growth, raising the risk of further second-round effects in domestic wage and price setting
- The risk of acting too late to prevent higher inflation expectations from becoming embedded in the economy, even in the face of weaker growth
The three members voting for an even larger rate rise wanted to lean more strongly against the risk that the recent strengthening in pay growth, firms’ pricing strategies and inflation expectations would become more firmly embedded.
Inflation to breach 10% at the end of this year…
The Bank have revised up their forecast for CPI inflation significantly, reflecting further rises in energy and commodity prices; an assumption that supply chain disruption will persist for longer; and a judgement that many firms will grant larger pay awards to retain and recruit staff.
After rising to an average of 9% in Q2 2022, inflation is expected to swing upwards again to 10.2% in Q4. Both peaks are largely driven by changes in Ofgem’s energy price cap. Following the 54% rise in the cap announced for April, the Bank expect another hefty rise (of 40%) in October – consistent with the current elevated level of energy futures contracts.
Aside from the cap, further upward pressure comes from higher global food and goods prices, in part reflecting renewed supply chain disruption following the invasion of Ukraine.
However, domestic price pressure is also expected to build further. Underlying wage growth is set to pick up, reflecting a tightening in the labour market and the impact of higher inflation itself.
But beyond this year, inflation is set to fall back – falling below the Bank’s 2% target in Q3 2024. This mostly reflects a stabilisation in energy prices and much lower goods price inflation, as global bottlenecks ease.
Less positively, the slowdown in domestic demand (and the impact on the labour market and spare capacity) moderate wage growth and firms’ ability to rebuild their margins.
…weighing significantly on economic growth
Higher inflation inevitably weighs on the growth outlook, through taking a chunk out of households’ real incomes. The Bank’s forecast for the fall in real incomes this year (1.75%) would mark one of the largest declines since records began (in 1964).
As a result, GDP growth slows over the first half of the BoE’s forecast period. It briefly dips below zero in Q4 – thanks to the second spike in inflation – but the economy is not expected to enter a technical recession (i.e. two or more consecutive quarters of falling GDP).
The real income squeeze means that household spending growth slows materially, but it nonetheless rises at a faster pace as incomes – and as consumers run down the stock of savings accumulated (in aggregate) during the pandemic.
Furthermore, the Bank expect some near-term support to growth from business investment, reflecting spending brought forward due to the superdeduction.
Read the Bank’s full Monetary Policy Report.