Expect the unexpected in the Bank of England’s battle with inflation

In the depths of lockdown, few imagined UK inflation would rise to a 40-year high of 9.1%, or that interest rates could rise so swiftly from their pandemic emergency levels of 0.1% to 1.25% today.

Whether high inflation could have been avoided, given the vast levels of stimulus, is difficult to gauge. What is clear is any hope of a post-pandemic return to normal was dashed, first by a resurgence of Covid-19 that prompted China to re-implement draconian lockdowns, and secondly by the twin shocks to energy and food markets delivered by Russia’s invasion of Ukraine.

A large proportion of current inflation is due to high global energy prices, resulting in electricity and gas prices in the CPI basket rising by 54% and 95% respectively over the year to May. The surge in inflation, however, is also becoming more broad-based, and 85% of the CPI basket is now recording inflation above 3%.

Core inflation, which excludes alcohol, food and energy, is at about 6%. Markets are implying UK policy rates of 3.25% by mid 2023. We believe this is unlikely given long-term economic fundamentals, the current state of the UK economy, and underlying drivers of current inflation. We expect policy rates to reach 1.75%.

The Bank of England has tightened policy at a relatively gradual pace so far, raising rates in 25 basis point increments since December 2021. This contrasts with the US Federal Reserve, which recently raised policy rates by 75 basis points in just one month.

Comparisons between the two economies first lie in the fact that the Bank began its rate tightening cycle several months earlier than the Fed. However, it also reflects fundamental differences between the two economies.

The Bank will be aiming to achieve a ‘neutral’ interest rate — the Goldilocks level for inflation-taming, at which monetary policy is neither expansionary nor contractionary. The appropriate neutral rate varies from country to country and depends upon an array of factors, including demographics and productivity growth.

Analysis indicates the neutral rate for the UK lies between 1.5% and 1.75%, whereas for the US, it is likely to be significantly higher, at around 2.5%. As such, our base case scenario is the Bank raises rates a further two times to take interest rates to 1.75%. In contrast, we expect the Fed to raise rates to 3.25%, higher than the neutral rate, to cool the overheating US economy and create sufficient slack in the labor market by raising the unemployment rate.

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The other key reason for our rates outlook relates to the health of the UK economy. GDP monthly outcomes suggest the UK economy has stalled since January. We see a rising risk of recession, as high inflation, waning fiscal support and higher interest rates push the economy to the brink. Surveys suggest consumer sentiment is currently at the lowest level since records began, and consumers are spending less on essentials.

It will be difficult for the Bank to raise rates and engineer a soft landing, and the path for rates will largely depend on the inflation trajectory. In the short term, we expect inflation to continue to rise, reaching a peak of more than 10% in October, when the energy price cap for 15 million households increases. After that, base effects will force inflation to trend sharply downwards, reaching 2.5% by the end of 2023.

Yet the risk lies on the upside. For central banks, the worry is the longer inflation remains above the target, the greater the risk that inflation becomes embedded in price-setting behavior, causing a change in inflation expectations and wage demands. Once wage growth accelerates in response to high inflation, it can set off a vicious price-wage spiral.

The question of how much higher policy rates can rise also depends on an assessment of the drivers of inflation and whether monetary policy can address the underlying source.

Our judgment is that much of the rise in UK inflation has been driven by external forces — especially energy input prices, supply shortages and import prices. The costs associated with the UK leaving the EU have also played a role, but this effect appears to be diminishing. On the other hand, if domestic sources of inflation prove to be larger, then the calculus could be different and more policy tightening may be necessary.

In the UK, many workers left the labor force over the past two years, some grappling with long-term illness, others with care-taking responsibilities. Some have emigrated following Brexit. This has pushed the unemployment rate to around 50-year lows at 3.7%. Job vacancies at 1.3 million are close to the total number of unemployed people, pushing wage growth to elevated levels. It remains to be seen whether workers return to the labor force, and whether the economy cools sufficiently that wage pressures ease.

Another consideration is the exchange rate. As a small open economy, the UK’s interest rate differential with the rest of the world heavily influences its inflationary dynamics via the exchange rate. The prospect of sterling depreciation is a key consideration. With the US embarking on an expeditious path of policy tightening, the risk is that sterling could see further depreciation pressure if the Bank fails to match the Federal Reserve. This would also argue for higher policy rate settings.

If the past two years have taught us anything, it is to expect the unexpected. We must be prepared for further economic and political shocks that could push interest rates towards a more hawkish outcome.

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