Simon French: All options open at Bank of England as global factors play out

However, the international backdrop since the Bank’s last meeting in mid-December has changed materially, and the outlook for UK growth and inflation since the Bank last published its forecasts has changed a lot. Governor Andrew Bailey will be under pressure to bring these factors together and update his view on what the economy can expect from monetary policy later in 2024.

Let us begin with what financial markets expect to happen. The latest pricing of interest rate swaps suggests the Bank of England’s policy interest rate will end the year at 4.25% – a full 1% lower than its current level. Whilst this scale of cuts is more than I suspect we will see, mortgage, loan and savings rates are being priced off these expectations. These abstractions have real world implications for the economy. At the very least the Bank will be required to comment on whether financial markets are off beam.
If the Governor and the policy committee disagree with the view of financial markets, then a pushback may be required. The latest economic forecasts presented by the Bank’s staff will shape that judgement. We can expect these forecasts to upgrade the growth outlook and reduce the inflation outlook from the numbers they presented to the committee in November.

What is driving this more upbeat outlook for the UK economy? Well for all the terrible events engulfing the Middle East, gas prices in Europe have halved in the last three months. This will feed through to lower energy costs for U.K. households and businesses from April and bring inflation down close to 2% a year – perhaps even briefly undershooting this level later in the year. This will put more disposable income back in the pockets of households and should facilitate higher discretionary consumer spending. That impact will be supplemented by cuts to National Insurance contributions revealed by the Chancellor in his Autumn Statement. The Bank have already revealed will add 0.25% to their November growth estimate. Throw in a slightly stronger value of the Pound – muting imported price inflation – and mortgage lenders offering lower interest rates, this all makes for an encouraging three months of data.

But the Bank’s judgment for appropriate UK monetary policy needs to account for what is still to come. In this regard, three big imponderables loom large.
Firstly, whilst no-one on the Monetary Policy Committee will publicly admit it, UK interest rates are largely influenced by economic events in the world’s largest economy: the United States of America. It is increasingly rare that a major central bank takes a divergent path to the US Federal Reserve. Doing so risks generating big swings in currency, or in the government cost of borrowing. So before signalling a path for UK interest rates the Committee are likely to look for clues from across the Atlantic. The US economy continues to defy conventional economic gravity – albeit fuelled by large deficits being run by the US state, and consumer credit accrued by her households. Economic growth at an annualized rate of 3.3% in the last quarter of 2023, and inflation of just 2.6% a year in December is an extraordinarily healthy mix of data that has led to red faces on even the most eminent of US economists. How US monetary policymakers respond to this in election year should not, in theory, influence thinking at the Bank of England. But it will.
Secondly, whilst inflation from imported goods, particularly energy, has fallen fast there are plenty of events from around the world to generate caution. The increase in shipping costs from disrupted trade through the Red Sea will take time to appear in UK consumer prices, but we are already seeing retailers warn of this risk. This week also sees the introduction of long-delayed Brexit frictions which will add to the costs of importing goods from the EU. There are more substantial import checks due to come into operation in April. The significance of these costs is hard to define with any certainty, and being largely supply issues could be seen as second-order concerns to monetary policy. But so wrong-footed were central banks by the scale of energy price inflation that it will inevitably weigh on the minds of policymakers. After all UK inflation is still running at twice its target rate and is expected to rise again when the January data is revealed.

Thirdly, domestic inflation is not yet tamed. There are some big increases to prices to come in the Spring. The state pension, working age benefits, the National Living Wage, as well as a range of commercial contracts like broadband and rents will go up by the rates of inflation that we saw last year. This “echo effect” in setting prices is a significant feature of the UK economy. Given what happened last April when similar increases to prices led to several months of UK inflation remaining much higher than seen in other countries, the Bank of England will be nervous of a repeat. The Governor will also be mindful of signalling a path for interest rates in February only to have a March Budget – widely expected to have further tax cutting measures – set the economy on a different path.

Together these factors lend themselves to the Bank leaving all options open. “Full optionality” is a phrase used by several central bankers during an economic cycle, the world over, that looks like nothing from the textbooks. If that means UK policymakers must be patient whilst events unfold then so be it. Such patience won’t be popular amongst government ministers. And that might just be the best argument for it.

Published on The Times: 29/01/2023