The Bank of England’s Monetary Policy Committee (MPC) met forecasters’ expectations by raising Bank Rate by 75bps – the largest increase since 1989. The scale of the rise was despite the Bank taking an even more downbeat view of the economy’s growth prospects and paring back its expectations for where inflation will peak. But the EY ITEM Club thinks the MPC will opt for smaller rate rises over its next few meetings.
The Bank of England’s new economic forecast is conditioned on interest rates rising to an implausibly high level. Its forecast of what would be the longest recession on record therefore appears equally implausible. But GDP is likely to see some decline over the next few quarters, with a backdrop of tighter fiscal policy and a weak global outlook. With interest rates now above the MPC’s previous estimates of the neutral level, and the prospect of tax rises and public spending cuts in the upcoming Autumn Statement, there’s a possibility that the macroeconomic policy stance is being tightened to an unnecessary degree.
The EY ITEM Club thinks that Bank Rate will peak no higher than 4% next year, below current market expectations of almost 5%. And given the prospect of policy contributing to inflation falling back quickly next year, it wouldn’t be surprising if the MPC started cutting rates at the turn of 2023 and 2024.
Meanwhile, the Bank of England confirmed its commitment to “actively” sell gilts bought under the Quantitative Easing (QE) programme. However, monetary policy is already being tightened via higher interest rates, other major central banks have yet to be as explicit as the Bank about when they'll sell their own bond holdings, and gilt issuance by the Government is increasing. Hence, Quantitative Tightening (QT) at present strikes the EY ITEM Club as a potentially risky step.
Martin Beck, chief economic advisor to the EY ITEM Club, says: “The 75bps rise in Bank Rate announced by the MPC today met the expectation of almost all forecasters and matched recent moves by both the US Federal Reserve and the European Central Bank. The rise was an especially significant one by past standards – the biggest since 1989 – and leaves Bank Rate at 3%, the highest since November 2008. But it wasn’t a unanimous decision, with one MPC member voting for a smaller 50bps increase and a second member favouring an even more modest 25bps rise.
“A tight labour market, strong pay growth, survey evidence of still-elevated price and wage expectations among businesses and the assumption that some form of support for energy bills would continue beyond the end of the Energy Price Guarantee next April were all cited by the MPC in support of its decision. But U-turns on tax cuts and the prospect of a tightening in fiscal policy in the Autumn Statement may well have held the MPC back from an even bigger rise in rates. The economy has also seen weaker performance than expected, with the Bank of England’s prediction for GDP growth in Q3 cut to -0.5% from -0.1%. And, as a result of the Energy Price Guarantee, inflation is now forecast to peak at 11%, down from the 13% expected previously.
“The MPC was unusually explicit in November’s policy statement in pushing back against investors’ expectations of where Bank Rate is heading. The latest economic forecasts were conditioned on market rate expectations in mid-to-late October, which had Bank Rate peaking at over 5% next autumn. Under that assumption, inflation would fall below the Bank of England’s 2% target by mid-2024 and reach zero by the end of 2025. Moreover, under the same interest rate assumption, GDP is forecast to see the most prolonged decline since the 1920s. The economy is projected to shrink 1.5% in 2023, unchanged from August, but then by a further 1% in 2024, compared with August’s forecast of a 0.25% fall. The jobless rate meanwhile would climb to 6.5% and economic challenges could thus intensify.
“While the EY ITEM Club thinks the MPC will continue to raise rates in its next few meetings, the size of those increases will likely be smaller than November’s exceptional rise. A recession over the next few quarters appears likely, which would add to the forces set to push inflation down next year. Bank Rate now sits well above the Bank of England’s most recent estimate of the “neutral” interest rate – the rate at which monetary policy is neither stimulating nor restricting economic growth – of around 2.25%. If speculation is accurate, the Autumn Statement will add to the fiscal tightening already announced, and monetary conditions in the UK face adverse spill-overs from equally significant rate rises in other major economies. With both monetary and fiscal policy being tightened into a downturn, there is potential that macro policy could already be heading towards a situation in which it could actually exacerbate the economic situation.
“The EY ITEM Club continues to predict that Bank Rate will peak at no more than 4% early next year, and were fiscal policy to be tightened by more than expected in the Autumn Statement, the high-point for rates could be lower.
“Meanwhile, the Bank of England confirmed its commitment to actively sell gilts bought under the Quantitative Easing programme. But with monetary policy being tightened via higher interest rates, other major central banks are yet to be as explicit as the Bank about when they'll sell their own bond holdings, and with the Government set to issue a considerable quantity of gilts in the near-future, Quantitative Tightening at present strikes the EY ITEM Club as a potentially risky step.”