• Interest rates rise, but market predictions of future rate hikes are running too hot
• Stagflation is coming
• Inflation is now expected to hit 10%
• Inflation forecasts show how impotent the central bank is
• Bank will look to start selling gilts from the QE programme
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“This inflationary car crash feels like it’s happening in slow motion. It’s been trundling towards us for a long time, but it’s only really just starting to bite down hard. Now the Bank of England is warning that we’re going to get double digit inflation, but not until the back end of this year. Energy prices, and in particular the Ofgem price cap review due in October, are driving the scale and timing of this inflationary peak.
“This is a far cry from the transitory inflation mantra that was being chanted last year, but to be fair to the Bank, the Ukraine crisis has seismically shifted the economic landscape. Inflation hitting 10% on the back of energy price rises, just as we hit winter, will only serve to raise the political pressure on the government to do something substantial to help households through a period of such exceptional pressure on everyday finances. This won’t be easy, given how bare the Treasury coffers are following the tremendous cost of the pandemic response.
“The Bank has pushed interest rates up to 1% to combat inflation, the highest level since the financial crisis. Three members of the committee wanted to go further, with a hike to 1.25%, which would mirror the US Federal Reserve’s 50 basis point increase delivered yesterday. The currency and bond markets were underwhelmed by the residual dovishness of the Bank of England, with the pound falling on the back of the decision, and bond yields slipping back too. This is a mark of how hawkish the market is expecting central banks to be. Policy makers are now being judged not only on delivering rate hikes, but the size of these increases too.
Rate hikes look set to disappoint
“There are hints that the market is getting ahead of itself by pencilling in UK interest rates rising to 2.5% next year though. Based on that assumption, the Bank forecasts inflation to fall back to 1.3% in three years’ time, which implies that the rate rises the market are expecting are actually too steep to simply get inflation back 2%. Meanwhile, the Bank projects that if interest rates stay at 1%, CPI inflation will be 2.2% in three years’ time, so closer to the Bank’s 2% target, and on the face of it therefore, a more likely prospect.
“Given such a volatile geopolitical and economic situation, inflation forecasts for three years’ time should be taken with a pinch of salt. But nonetheless, they are what the rate setting committee has to work with, and will inform monetary policy decisions. The Bank’s anaemic projections for inflation in the longer term suggest policymakers won’t push rates up as high as the market is currently pricing in. The fact that CPI inflation is set to fall back so much, even with interest rates at current levels, also speaks to the impotence of central banks in the face of the price rises currently facing the global economy. What the Bank of England really wants to control with tighter monetary policy isn’t so much short-term inflation, as inflation expectations, which could lead to longer term price rises if they get embedded.
Stagflation is coming
“The Bank is also now projecting a period of stagflation, with no growth in GDP expected over the next year, but inflation forecast to run at 6.6%. Again, this suggests the monetary policy response in coming months may be more dovish than anticipated, because the UK economy is on the brink of toppling backwards, and too many nudges from the central bank could be the catalyst for a recession. This shows the Bank is stuck between a rock and a hard place, trying to act tough on inflation, while at the same time not doing too much damage to economic growth.
More QE unwinding can begin
“The rise in interest rates to 1% also now opens the door to more Quantitative Tightening, as the central bank unwinds the Quantitative Easing programme initiated in 2009 in response to the financial crisis. Until now the Bank has simply not been reinvesting the proceeds of bonds within the scheme, but crossing the 1% interest rate threshold now means the Bank can start selling gilts held as part of the QE programme too. It’s somewhat disconcerting that the MPC has only just asked Bank staff to work on a strategy for government bond sales, seeing as this has been on the cards for some time. The outcome of this work is expected to be announced in August, from which point we can expect the Bank to begin sales, which will serve to heap further pressure on bond prices.”