The Bank of England’s risky forecasts have delayed the fight against inflation.
The Bank of England (BoE) surprised the markets by raising its rates by 50bp. After a period of stability at a high level, core inflation has started to rise again due to persistent wage pressures. BoE rates could rise further to reach 6% in the fall of 2023. The monetary policy error linked to risky forecasts will have serious consequences for borrowers, especially since the British Treasury has no margin of maneuver to lighten the mortgage burden on households. According to our estimates, the BoE’s neutral rate is close to 4%. Rates should therefore remain high for a long time, in order to ensure a lasting decline in inflation.
A CERTAIN CONSTANCE IN INCOHERENCE
The BoE is one of a kind. Its decision-making process is often difficult to grasp, even as the Bank pursues a standard inflation target of 2%. While strategic ambiguity is not necessarily a bad thing in the conduct of monetary policy, the central bankers of the BoE make particularly intensive use of it. Indeed, the governor of the BoE, Andrew Bailey, does not hesitate to play with the markets, as in November 2021, by giving up a rise yet telegraphed before raising interest rates a month later with the same data available.
Moreover, unanimity is rare. Split decisions in the Monetary Policy Committee (MPC) are more common than in other central banks. Since December 2022, two of the nine MPC members have consistently voted to keep rates unchanged, even as the BoE embarked on a cycle of monetary tightening.
THE BOE’S LATE RESPONSE TO INFLATION
The BoE did not react in time to the rise in inflation. The Bank must now commit to controlling it and therefore communicate a credible strategy to achieve this. Since the summer of 2021, UK consumer price inflation has been well above target. The British economy is undoubtedly operating above its potential, which remains constrained by the supply shocks since Covid and the consequences of Brexit.
In November 2022 and February 2023, the Bank’s forecast pointed to a prolonged recession in the UK expected to create a gap in potential output sufficient to ease price pressures. In hindsight, the Bank’s forecast looks like reverse engineering to justify a very moderate hike cycle.
Forecasting errors are commonplace, but failing to take upside price risks into account is a serious mistake. The 2025 inflation forecast published in February was 0%! The revision to 1% inflation in two years, made in May, remains just as doubtful.
Disinflation is far from certain. Headline inflation remained stable at 8.7% year-on-year in May after another significant upside surprise against consensus. Core inflation stands at 7.2%, reflecting persistent imbalances in the UK labor market. Wage growth is hovering around 6-7% on an annual basis and shows little sign of slowing as the UK unemployment rate remains below 4%. The second-round effects feared by central banks are visible in the British economy.
THE JUNE SURPRISE
At its meeting on June 21, 2023, the MPC voted by a majority of 7 votes to 2 to increase the BoE’s key rates by 50bp to 5%. The BoE’s decision to raise rates by more than 25bp comes as a surprise, but it appears fully justified by the latest data. Two members of the MPC, Silvana Tenreyro and Swati Dhingra would nevertheless have preferred to keep rates unchanged at 4.5%.
There was little reaction from central bankers on reading market expectations pointing to a terminal rate of 6%. New increases are therefore likely at the next committee meetings until the autumn.
Monetary tightening has obvious consequences for businesses and households. Many borrowers currently paying variable mortgage rates or who need to refinance their fixed rate mortgage are being offered two-year fixed rates above 6%. For an average household, the increase in repayments reaches around 2,500 pounds per year. Chancellor Jeremy Hunt has ruled out mortgage interest relief, as fiscal support for households in financial difficulty would risk fueling further inflation. Instead, the Chancellor is encouraging banks to show some leniency to their struggling customers. Under the December 2022 agreement between banks, regulators and the Treasury, lenders are required to support those struggling to repay their mortgages by modifying terms with an extension of mortgage maturities or by limiting , temporarily, interest repayment. A suspension of foreclosures was also decided on Friday. It should be kept in mind that foreclosures and mortgage arrears today still remain below pre-pandemic levels.
This article is originally published on allnews.ch
