Andrew Bailey: “We think so [the] bank rate will have to rise by less than the current price in financial markets’ © FT Montage/PA
The Bank of England painted two pictures of the outlook for the UK economy on Thursday. Both scenarios were bleak.
Whatever happens, the central bank said, Britain’s economy is slipping into a recession that will 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 a decline in gross domestic product and a “very challenging” outlook.
Andrew Bailey, governor of the BoE, said this was inevitable as there were “important differences between what the UK and Europe are facing in terms of shocks and what the US is experiencing”. Europe, unlike the US, has been grappling with rising gas prices since Russia’s invasion of Ukraine.
The BoE’s gloomy forecasts did not end with the recession. Inflation will 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, will end next year above 4 percent.
If all this pain was common to both BoE scenarios, the differences between them were key to the central bank’s messages.
In the BoE’s first scenario – generally regarded as its flagship forecast – the forecasts are based on the assumption that financial markets’ expectations for future interest rates will include them peaking at 5.25% next year.
If interest rates reach this level, the BoE’s Monetary Policy Committee believes that the UK will most likely have to suffer eight quarters of economic contraction: the longest recession since the Second World War. Unemployment will rise to 6.4 percent. This economic pain will weigh on inflation, sending it to zero by the end of 2025.
But with the BoE targeting an inflation rate of 2 per cent, Bailey was clear that this scenario meant markets risked getting their bets on future monetary policy wrong. “We think [the] the bank rate will have to rise by less than the current price in the financial markets,” Bailey said.
The BoE’s alternative scenario – which is usually buried in the central bank’s forecast documents – that interest rates remain constant at the current level of 3 percent, was given much more weight in the presentations by Bailey and his team.
Under this projection, output would still contract, but only by half as much as in the first scenario, resulting in a mild recession by historical standards. Inflation will fall to 2.2 percent in two years before falling below the BoE’s target. Unemployment will rise, but only to 5.1 percent.
Many economists said the BoE’s alternative scenario was a clear signal from the central bank that it was close to finishing raising interest rates, now raising them from 0.1 percent a year ago to 3 percent, the highest level since 2008
Kallum Pickering, an economist at Berenberg, said the recessionary overreach 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 to return inflation to its 2 percent target’.
Asked which of his two scenarios the BoE thought was most likely to happen, Bailey would not be drawn. He declined to commit to a specific view on future interest rates, saying: “When the truth is between the two, we don’t give guidance on that.”
His main reason for declining to be more specific was the possibility that inflation could turn out to be stronger than the BoE currently thinks.
Bailey said that while no forecast would ever be exactly right, the main risk was that inflation would still be higher than central forecasts in both BoE scenarios.
One key danger for the BoE is that wage growth could easily remain higher than it would like, with companies feeling able to raise prices without losing too much business.
Ruth Gregory, an 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 prove “stickier” than hoped.
Markets barely noticed the BoE’s dovish scenario by the end of the day. Ahead of the BoE’s midday announcement, markets were pricing in interest rates peaking at 4.75 percent next year. By the end of the day, they were betting it would hit 4.72 percent in September.
Market expectations for future monetary policy will change and Bailey was keen to highlight what will guide the BoE’s decisions in the coming weeks.
Most important, he said, will be the development of economic data, especially on wages and the pricing strategies of firms. If they soften, the BoE will feel less need to raise interest rates further.
The path of wholesale energy prices would also be crucial and the BoE will be hoping they slow further after falling by more than half since late August.
The other deciding factor will be Chancellor Jeremy Hunt’s Autumn Statement on 17 November. If the government proceeds with immediate public spending cuts and tax increases to plug a gaping hole in public finances, it will further depress the economy and reduce 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 happen “in the relatively near term” to influence the central bank’s interest rate decisions.
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