• Bank now expects consumers to spend 10% of their accumulated lockdown savings, up from 5% forecast in February
• The Bank has sharply upgraded economic forecasts for the UK
• Unemployment rate is now expected to peak at 5.5%, down from 7.75% projected in February
• Markets are turning attention to the timing of interest rate rises
• Why QE unwinding matters to government finances
Laith Khalaf, financial analyst at AJ Bell, comments:
“The Bank of England is expecting a consumer spending spree to fuel an explosive economic recovery this year, funded by the war chest savers have built up throughout the pandemic. In February, the Bank predicted 5% of these excess savings would be spent, but that’s now been upgraded to 10%.
“The doubling in this forecast tells us there is a high degree of uncertainty in estimates of just how extravagant consumer spending is going to be. This is a unique situation, where consumers have been restrained by law and are now being gradually let off the leash, so even the best spreadsheets at the Bank of England aren’t going to nail this forecast with any precision. If consumers really let rip, the economy could be heading for a big boom. But if they play it safe, that will moderate the recovery.
“The Bank has also pinned back its forecast for unemployment, which was expected to rise to 7.75%, and is now forecast to peak at 5.5%. If this prediction holds true, it’s tremendous news for UK workers and businesses, and for government finances too. Of course, one of the big swing factors in the improved outlook for unemployment is the extension of the furlough scheme, which looks like it will dig the UK economy out of a very nasty hole.
“The improved outlook for the UK economy is extremely positive, but it does mean markets will increasingly turn their attention to interest rate rises, and that could create some turbulence. Over the last twelve years, low interest rates have inflated the prices of a wide range of assets, including shares, bonds and property. Tighter monetary policy would mean these assets start to feel the pull of economic gravity a bit more forcefully. Shares and property prices might well get an upward push from robust economic growth, which could offset the negative effects of higher interest rates. But government bonds wouldn’t escape so lightly and could face a double whammy of both tighter monetary policy and a strong economic recovery, which would reduce the appeal of holding safe haven assets.
“The Bank of England has reasserted it is fairly relaxed about the prospects for inflation and so feels little pressure to raise interest rates. It will also attribute a higher weight to downside risks to its projections when deciding the path of monetary policy, which means they will err on the side of lower rates. But modest expectations of tighter monetary policy have already begun to find their way into market prices. The ten-year gilt yield now stands at 0.8%, up from 0.2% at the beginning of the year. Meanwhile interest rate markets are now pricing in a 25% chance of a rate hike in the next 12 months and have discounted any chance of a rate cut.
“Tighter policy doesn’t just mean a rise in the base rate either, there’s the unwinding of QE to consider too. The present guidelines state that QE would not start to be unwound until interest rates reached around 1.5%, but the Bank is currently reviewing this position. If the Bank decides to reduce this target, it could have a massive market impact, as the QE programme governs the fate of £875 billion of government bonds. A lower floor brings forward the date at which the Bank can be expected to reduce its gilt holdings, and consequently reduces the appeal of holding government bonds. Notably the Bank’s chief economist, Andy Haldane, voted for QE to be scaled back a touch at this latest meeting, though he is soon to be leaving the Bank of England, so won’t have an impact on monetary policy beyond the summer.
“The potentially destabilising effect on government finances will no doubt be a consideration in the Bank’s decision on how to unwind QE. The Treasury currently pays bank rate of 0.1% on gilts held in the QE programme, rather than the full coupon, collectively around 2.1%. As a result, any rise in base rate has a big impact on the Exchequer, because so much of its debt is currently held by the Bank of England. In its March Budget forecasts, the OBR calculated that a 1% rise in interest rates would present the Chancellor with a bill for a further £20.8 billion in debt interest in 2025/26. To put this figure in context, that would wipe out the extra tax collected from freezing income tax allowances, and cancel off a big chunk of the corporation tax rise too. A gentler unwinding of QE before base rate starts to rise might help to cushion the shock of interest rate rises on the existing stack of government debt. Then again, if it sparks a bond sell off, it will push up the cost of fresh borrowing for the Exchequer. In technical circles, this is known as being stuck between a rock and a hard place.”
