The Bank of England has warned that the cost of living crisis could plunge the economy into recession this year, as it increased interest rates to tackle soaring inflation that is expected to rise above 10% in the coming months.
Threadneedle Street’s monetary policy committee (MPC) voted by a majority to raise its base rate from 0.75% to 1%, lifting the cost of borrowing to the highest level in 13 years, as it sounded the alarm over the risks from spiralling inflation exacerbated by Russia’s war in Ukraine.
Despite the growing risks to the economy as households endured one of the biggest annual declines in their income for decades, the Bank said a quarter-point rise was warranted to block persistently high inflation from taking hold, as the shock from soaring energy costs rippled through the global economy.
Issuing a downbeat verdict as voters went to the polls in local elections, the Bank predicted Britain was on track for years of meagre economic growth as people cut back their spending to deal with the heavy blow to living standards.
Against a backdrop of soaring international energy prices, household gas and electricity bills are expected to rise by 40% in October, after the government offset only some of last month’s record rise using measures outlined in Rishi Sunak’s spring statement.
With the chancellor under pressure to launch a fresh support package for householders, the Bank said consumers tightening their belts to deal with the cost of living crisis was likely to push the economy into a sharp contraction in the fourth quarter.
Although a modest recovery is expected at the start of next year, ensuring two consecutive quarters of falling GDP (the technical definition of a recession) is likely to be avoided, the Bank warned Britain’s economy would shrink by 0.25% over the course of 2023 as a whole, in effect a slow-burn recession.
The ‘cost of living crisis’ means the UK may be on the brink of recession, warns Steven Bell, chief economist at BMO GAM:
Inflation is running well ahead of wages and the government has intensified the squeeze by raising taxes. In addition, the small army of people employed to tackle the pandemic is being disbanded.
Real personal incomes are set to fall by 2.5% this year, the biggest decline since records began in 1947. The Bloomberg consensus survey of forecasts sees UK GDP in 2022Q2 increasing by only 0.2% compared with Q1.
Before the Ukraine war, that consensus was for a healthy 0.9% increase. Indeed, a significant minority are now expecting an outright fall in GDP in Q2 2022.
Katharine Neiss, chief European economist at PGIM Fixed Income says there is a risk the Bank could be pushed into setting even higher rates into a recession, as a falling pound pushes up inflation.
The BoE is in arguably the most difficult situation among major central banks.
With inflation expected to peak in the double digits by year-end and growth likely to more than halve into next year, according to the central bank’s latest forecasts, it is the prospect of prolonged above target inflation that is driving policy decisions for now.
James Smith of ING sees clear hints that the Bank’s MPC committee thinks that is going to be too aggressive.
“Policymakers are clearly divided, and three voters opted for a 50bp move this time. It’s clear that the committee is divided on just how concerned it should be about the tight jobs market, faster wage growth and elevated consumer inflation expectations.
“In short, expect more hikes, but not as many as markets expect. We’d already pencilled in another rate rise for June and we suspect on the basis of today’s split decision, another one could follow in August. But the new forecasts, taken together with the increasing division among committee members, suggest the Bank is getting closer to a pause in its tightening cycle.”
Newsnight’s Ben Chu has produced some neat charts of the Bank’s forecasts:
The minutes of the Bank’s meeting highlight the split among policymakers as they try to curb inflation at the risk of pushing the economy into recession.
They show that “most members of the Committee” judged that some degree of further tightening might still be appropriate in the coming months, although views differed about the balance of risks.
But some members of the Committee judged that the risks around activity and inflation over the policy horizon were “more evenly balanced and that such guidance was not appropriate at this juncture”.
The pound has plunged, hitting its lowest level since June 2020, on growing fears that the UK could fall into recession.
Sterling has slumped to $1.2375, down nearly nearly two and half cents today, on track for its worst day since March 2020, when the pandemic caused markets to crash.
You might expect a rise in interest rates to strengthen a currency, especially as three of the nine policymakers wanted a larger, 50 basis-point rise to 1.25%.
Instead, the split at the Bank of England, the sharp cut to growth forecasts, and the prospect of even higher inflation is hurting the pound.
Matthew Ryan, senior market analyst at global financial service firm, Ebury, says the Bank’s Monetary Policy Committee looks more divided on policy than we’ve seen in some time.
The vote on interest rates was more hawkish than we had expected, with all nine members in support of an immediate hike and three in favour of a 50 basis point move. The bank’s inflation assessment was also upgraded, with price growth now set to peak in excess of 10% later this year.
“The MPC does, however, appear highly concerned about the impact of rising commodity prices on growth, and now expects the UK economy to contract in 2023. The tweaking of the bank’s wording on future policy moves is all pretty vague and muddled, and suggests to us that policymakers are unsure on upcoming policy moves ahead of a potentially damaging period of ‘stagflation’.
Sterling has reacted to the bank’s lack of clarity, and indeed the threat of a UK recession, in a negative fashion and is currently back trading below the 1.24 level versus the US dollar.”
Fawad Razaqzada, market analyst at City Index and FOREX.com, agrees that stagflation worries are hitting the pound:
The divided MPC thinks CPI will peak above 10% and the economy is facing a very sharp slowdown.
The spilt in votes and uncertainty over inflation and growth puts rate setters in a tricky dilemma. Balancing inflation against growth will be very difficult.
So, the key risk facing the UK is not necessarily tighter policy, but uncertainty over monetary policy and, more to the point, stagflation.
As fears grow that the UK is heading for a contraction in output, amid rising prices domestically and abroad, weak growth in eurozone due to the Russia-Ukraine conflict, and China’s lockdowns, this should keep the pound’s upside limited.
Q: You’ve been cautious about using the term ‘stagflation’ – but this is stagflation, isn’t it? How worried should households be?
Bailey says he avoids the term, as it doesn’t have a good definition.
“The main reason I don’t tend to use the word is that it is not in my view very well-defined.
[An economy facing double-digit inflation and the risk of a contraction doesn’t sound like the worst definition, though…]
Q: What do you say to struggling households who will feel you’ve just given them another kick?
Bailey says some people think the Bank should raise interest rates even higher. He doesn’t, so policy is ‘calibrated’ to reflect the balance of risks.
The Bank has also revised up its forecast for wage growth, he expains, saying that companies tell him they’ve ‘really struggling’ to hire staff.
The conversation with businesses often goes ‘well I know you say there is going to be this big downturn in the economy’ but it is not coming from where they see it, and their real concern is they just can’t hire enough people to meet the demand they have today.”
Q: When you say there’s nothing the Bank can do to protect people from this hit, as you saying ‘over to you, chancellor’?
Governor Andrew Bailey says the Bank never advises government on policy, it is simply pointing out that monetary policy has its limits.
Q: Is the pain that households are facing the only way to get inflation down? Is it medicine we need to take?
Andrew Bailey explains that the shock to real incomes (from the surge in prices) will be the main downward driver on inflation, rather than monetary policy.
The biggest driver is the real income shock which is coming from the change in the terms of trade, particularly from energy prices, and from some core goods and some food.
The hit to incomes in the UK from surging energy and imported goods costs are “unavoidable”, warns deputy governor Ben Broadbent.
Monetary policy (changing interest rates) cannot offset it, he explains.
Broadbent says the Ofgem energy cap is likely to increase by around £1,500 during 2022 (April’s rise, plus the one coming in October), on top of a £300 increase in 2021.
You can double that hit, if you add the increase in imported goods prices due to the Ukraine war.
In contrast, the impact of raising interest rates on mortgage costs is a fraction, perhaps just a tenth, he adds.
Q: Your forecasts looks very much like a recession, so how can you justify exacerbating the pressures on households and businesses in the cost of living crisis?
BoE Governor Andrew Bailey says the Bank’s forecast show a “very sharp slowdown”, although not a technical recession (two consecutive quarters of negative growth).
Explaining today’s rate rise, Bailey says the Bank is walking a very narrow path, and cites two risks.
First, the UK’s very tight labour market, and the pressure on wages as firms struggle to hire staff.
Second, the question of how savings build up during the pandemic will be used.
Bank of England governor Andrew Bailey is holding a press conference now.
He explains that inflationary pressures have ‘intensified sharply’ since the Ukraine war began, and that Russia’s invasion has led to a material deterioration in the global economic outlook.
With inflation already well over the Bank’s 2% target, the risks to inflation are skewed to the upside, Bailey says. But when CPI inflation falls it will fall rapidly, he predicts.