The BoE outlines two dire scenarios for taming inflation

The Bank of England painted two pictures of the outlook for the UK economy on Thursday. Both scenarios were grim.

Whatever happens, the central bank said the UK economy is slipping into a recession that will last at least all of next year. Unlike the Federal Reserve, which was still hoping for a “soft landing” for the US economy on Wednesday, the BoE spoke of falling gross domestic product and a “very challenging” outlook.

BoE Governor Andrew Bailey said it was inevitable as there were “key differences between what the UK and Europe face in terms of shocks and what the US is experiencing”. Unlike the US, Europe has been struggling with rising gas prices following the Russian invasion of Ukraine.

The BoE’s gloomy predictions did not end in a recession. Inflation would remain above 10 percent for the next six months and above 5 percent throughout 2023. Unemployment, currently at a 50-year low of 3.5 percent, would be above 4 percent by the end of next year.

Line chart of UK GDP (Q2 2022 = 100) showing In both scenarios, the BoE expects a long recession

If all of this pain was common to both BoE scenarios, the differences between them were key to the central bank’s message.

In the first BoE scenario – which is usually considered the main forecast – the predictions were based on the assumption that financial markets’ expectations for future interest rates would include a peak of 5.25 percent next year.

Should interest rates reach this level, the BoE’s monetary policy committee believed that the UK would most likely suffer 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, pushing it down to zero by the end of 2025.

But given that the BoE has a 2 percent inflation target, Bailey was aware that this scenario suggests that markets risk getting their bets on future monetary policy wrong. “We believe [the] Bank rates need to rise less than what is currently priced into financial markets,” Bailey said.

The BoE’s alternative scenario – usually hidden in central bank forecasting documents – of interest rates holding at the current 3% level was given much more prominence in the presentations by Bailey and his team.

Under this forecast, production would still contract, but at half the rate of the first scenario, resulting in a mild recession by historical standards. Inflation would fall to 2.2 percent in 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 is a clear signal from the central bank that it is almost done raising interest rates, which have now increased them to 3 percent from 0.1 percent a year ago, the highest level since 2008.

Line chart of UK CPI inflation (%), showing that inflation is expected to remain in double digits for the next six months

Berenberg economist Kallum Pickering said recessionary overkill in the BoE’s first scenario means the central bank “may have to do much, much less than the market expects in terms of further rate hikes to get inflation back to its 2 percent mark.” – target to bring”.

When asked which of the two scenarios the BoE thought was the most likely, Bailey didn’t answer. He did not want to commit himself to a specific view of future interest rates: “We do not provide any orientation where the truth lies between the two.”

His main reason for refusing to be more specific is the possibility that inflation will prove firmer than the BoE currently thinks.

Bailey said that while no forecast would ever be spot on, the main risk is that inflation would still be higher than central forecasts in both BoE scenarios.

A key danger for the BoE is that wage growth could remain slightly higher than it would like as companies feel able to raise prices without losing too much business.

Ruth Gregory, economist at Capital Economics, said the BoE’s many upward revisions to market expectations for future interest rates over the past year suggested inflation could be proving “more stubborn” than hoped.

By the end of the day, markets had barely taken notice of the BoE’s dovish scenario. Ahead of the BoE’s midday announcement, markets were pricing in interest rates that would peak next year at 4.75 percent. At the end of the day, they bet they would top next September at 4.72 percent.

Line chart of policy rate and subsequent BoE forecasts (%), showing rates are already higher than the path assumed by the BoE in August

Market expectations for future monetary policy will change and Bailey wanted to highlight what would guide BoE decisions in the coming weeks.

Most important is the development of economic data, especially wages and pricing strategies of companies. If these abate, the BoE would see less need to raise rates further.

The evolution of wholesale energy prices would also be key and the BoE hopes these will weaken further after more than halving since late August.

The other deciding factor will be Chancellor Jeremy Hunt’s fall statement on November 17th. If the government proceeds with immediate public spending cuts and tax hikes to fill a gaping hole in public finances, it will further weigh on the economy and ease pressure on the BoE to hike interest rates.

Ben Broadbent, BoE deputy governor, suggested that fiscal action by the government would need to be “relatively short-term” to influence central bank rate decisions. The BoE outlines two dire scenarios for taming inflation

Adam Bradshaw

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