05 August 2022
The Bank of England’s first 50 basis points (bps) rise in almost 30 years will also be its last of that magnitude. With a recession equivalent to that of the 1990’s now looking inevitable, the Monetary Policy Committee (MPC) is likely to conclude that further large rises are likely to do more harm than good.
However, the MPC still has plenty of work to do. Inflation is likely to hit 13% by the end of the year, and will still be above 6% by the end of 2023. We expect four 25bps hikes over the next six months to take rates to 2.75% in early 2023.
Middle market businesses should brace for an extended period of shrinking and weak demand, rapidly rising energy costs and higher interest rates.
Recession now unavoidable
The 8-1 vote in favour of a 50bps hike (the other member of the committee wanted a rise of 25bps) illustrates the fundamental challenge facing the MPC – how to reconcile a looming recession with soaring inflation?
The latest report from the MPC makes pretty dismal reading.
The Bank now expects inflation to reach 13% in October, when energy regulator Ofgem is likely to raise the energy price cap by a whopping 75%. Indeed, the MPC estimates that the direct contribution of energy to CPI inflation will be 6.5ppts, and the indirect contribution (because businesses put up their prices to recoup higher energy prices) will be another 1ppt. So, of that 13% inflation rate in Q4, at least 7.5ppt will be due to higher gas and electricity prices.
And even though inflation will drop sharply after the October peak, it won’t fall back to the 2% target until the end of 2024. However, based on market rate expectations the Bank forecasts that CPI inflation will be far below the 2% target in three years’ time, suggesting that the Bank doesn’t think rates need to rise to the 3% priced into the market and/or that further down the road rates may need to be cut. Given the huge amount of uncertainty generated by the war in Ukraine, however, forecasts this far out should be taken with a whole handful of salt.
The huge surge in energy prices means that household’s real incomes are set to fall by about 2% in both 2022 and 2023. This record-breaking drop in household incomes will lead to a fall in consumer spending and a contraction in GDP.
As a result, a recession looks unavoidable. The MPC now expects the economy to shrink by almost 1% q/q in Q4 2022, to be followed by another quarterly fall – more than meeting the normal definition of a recession (ie two consecutive quarterly falls in GDP).
Overall, the economy is likely to shrink by 2.2% from peak to trough. To put that into context, it’s roughly the same as the 1990s recession and significantly smaller than the financial crisis, which saw a peak-to-trough fall of about 6% and a fraction of the 22% fall seen during the pandemic.
The big picture, though, is that the economy is still on track to be smaller in 2025 than it was in 2019, before the pandemic.
The much weaker economy is likely to create more unemployment. The MPC sees the unemployment rate reaching 6% by the end of 2025. That would be the highest rate since 2014 and would prove a huge headache for whoever is the next Prime Minister, especially with the next general election scheduled for January 2025.
One big caveat to the committee’s forecast is that the next Prime Minister is expected to provide material support to households through the winter. A big fiscal boost would be enough to reduce the scale of the hit to GDP, though given the BOE’s pessimism it’s unlikely the committee would judge this to be enough to avoid a recession altogether.
How far will interest rates rise?
The MPC left the door ajar for further 50bps rate hikes by saying, ‘The scale, pace and timing of any further increases in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response.’
But in the face of the dire economic forecasts, we think the committee will opt for 25bps rises from now on. The committee has actually said that ‘policy is not on a pre-set path’ and that the MPC will decide the ‘appropriate level of Bank Rate at each meeting’.
Our base case is for four increases of 25bps over the next six months, which will take interest rates to 2.75%. We think the MPC will then pause as it becomes clear that inflation is on a downward trajectory and the economy is in recession. In fact, attention will probably turn quite swiftly to when and by how much the MPC will start to cut rates!
Quantitative tightening beginning in earnest
The MPC said that it is ‘provisionally minded’ to commence gilt sales of £10bn per quarter from the end of September. Remember, the MPC has already stopped reinvesting the proceeds from maturing assets so these active gilt sales will be in addition to that. As a result, the Bank’s balance sheet will shrink by about £80bn over the next year or so.
However, at its press conference the MPC was insistent that the policy tool of choice was interest rates and not gilt sales. So, if the economy does worse than expected, don’t expect a return to quantitative easing.