Bank of England confronts policy dilemma over inflation surge

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UK interest rate setters will have a lot of explaining to do when they publish their latest decision along with an updated assessment of the economic outlook on Thursday.

In May, the Bank of England said inflation would overshoot its 2 per cent target only briefly at the end of this year, before ebbing as energy prices stabilise and supply chain bottlenecks ease. Andy Haldane, who recently stepped down as the bank’s chief economist, was the only member of the monetary policy committee to vote for tighter policy to head off the threat to price stability.

But inflation has overshot the BoE’s forecasts for three successive months, hitting 2.5 per cent in June, with economists predicting it could peak close to 4 per cent and linger above target.

Line chart of CPI annual inflation rate (%) showing The BoE has underestimated the rise in inflation this year

Analysts do not expect a change in monetary policy at this meeting, but given the speed at which the committee’s projections have been overtaken by events, here are four things to watch for in Thursday’s report.

How durable does the BoE think the recovery will be?

The MPC could raise its forecasts for growth in the near term, as it signalled after its June meeting, to reflect the speed of the recovery witnessed in the early stages of reopening, and the unexpected strength of the labour market.

But that does not necessarily mean it will upgrade the medium term outlook, with recent data suggesting that consumers have become more cautious following the spread of the Covid-19 Delta variant, and that problems in supply chains have held back production.

“The last miles are set to be the hardest,” warned Fabrice Montagné, economist at Barclays, who thought the BoE’s forecasts would still show output 2 per cent below its pre-Covid trajectory at the end of 2022.

Can the inflation spike still be justified as temporary?

The new forecasts will almost certainly show inflation rising further above the BoE’s 2 per cent target, and staying high for longer than was projected in May. As Philip Shaw, economist at investment bank Investec, noted, the debate “is similar to that which is taking place within the [US Federal Reserve], notably whether price pressures are becoming entrenched or are transitory”.

Andrew Bailey, BoE governor, argued last month that the jump in inflation was partly because of base effects, caused by last year’s swings in energy prices, and to short-term bottlenecks in global supply chains. He argued that price pressures would ease as consumers spread their spending more evenly again over both goods and services.

Line chart showing UK inflation has risen rapidly to a three-year high

However, Ben Broadbent, the BoE deputy governor for monetary policy, acknowledged last month it was hard to “fully account for the unusual strength of inflation”, and that some pressures on prices could persist — especially if mismatches in the labour market lead to higher wage growth. 

How far has the MPC shifted towards tightening policy?

Michael Saunders, an external MPC member, has sent the strongest signal that he is now inclined to vote for an early end to quantitative easing, saying last month that “it may become appropriate fairly soon to withdraw some of the current monetary stimulus”.

Sir Dave Ramsden, BoE deputy governor for banking and markets, has also taken a more hawkish tone, saying the conditions for tightening could be met “somewhat sooner than I had previously expected”.

But other committee members, including Jan Vlieghe and Jonathan Haskel, have said explicitly that they think it is too early to tighten policy and risk choking off the recovery. Most economists think the majority of the MPC, which is understrength at eight members pending Haldane’s replacement, will vote to hold interest rates at 0.1 per cent, and to leave its target for quantitative easing unchanged. The current pace of asset purchases is set to bring the stock of gilts to £875bn by the end of the year.

There are two reasons for caution: uncertainty over whether vaccines will be enough to stop the spread of the Delta variant placing too much strain on hospitals; and the potential for fresh job losses as the furlough scheme winds down and other forms of government support are withdrawn.

“Our hunch is that the MPC will want to bide its time,” said Ruth Gregory, at the consultancy Capital Economics.

Will the BoE say any more about how it will sequence the withdrawal of stimulus?

The BoE is conducting an internal review to determine how it will withdraw stimulus when it does start to tighten policy, revisiting its previous position that it would only start to unwind quantitative easing after it had raised interest rates to at least 1.5 per cent.

Bailey has hinted that the BoE would not necessarily wait until that point before cutting its stock of assets — and could even opt to start reducing its balance sheet before the first rise in interest rates.

The MPC is unlikely to reach conclusions until later in the year, but markets will be watching for any hints on how the principles of its approach might change.

Hande Kucuk, deputy director of the National Institute for Economic and Social Research, a think-tank, argued that rising inflation had made it urgent for the BoE to explain how it will approach tapering, to avoid a market upset that could jeopardise the recovery when it does act.

“Now is the time for the monetary policy committee to prepare the ground,” she said, adding that a clearly communicated, gradual approach was needed “to avoid a significant tightening in financial conditions that might risk the ongoing recovery from the pandemic”.

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