Yahoo Finance Bank of England risks economic self-harm as inflation tumbles
The bigger than expected drop in November’s inflation figures is good news on the face of it.
But it comes with an edge: the Bank of England’s insistence on keeping interest rates higher for longer is looking more and more absurd, economists have warned. Unless policymakers change tack, Threadneedle Street risks needlessly tipping the economy into recession.
Inflation dropped from 4.6pc to 3.9pc between October and November, a far bigger drop than economists had predicted. Forecasters had pencilled in a drop to 4.3pc.
Crucially, the figure was far below the Bank’s expectations – yet again. The Bank had forecast inflation would be 4.8pc in October and 4.6pc in November.
“The facts are changing before the Monetary Policy Committee’s eyes,” says Sandra Horsfield, economist at Investec.
While the numbers are changing, the Bank’s messaging is not.
Chief economist Huw Pill offered a fleeting flash of hope last month when he said market bets on a first rate cut in August 2024 did not “seem totally unreasonable”.
But the Bank quashed the sentiment almost immediately. Two days later, Governor Andrew Bailey said it was “too early to be talking about cutting rates” and dismissed market expectations.
Since then, officials have doubled down on this message. At the last interest rate decision on December 14, Bailey warned that rates in the UK may actually need to rise again. Three members of the Monetary Policy Committee voted to put the Bank Rate up to 5.5pc.
The drum beat has continued: in recent days, deputy governor Ben Broadbent signalled that pay was not falling fast enough to start cutting rates, while fellow policymaker Sarah Breeden said “our job isn’t done”.
The tough talk has been in direct contrast to the US Federal Reserve, which has clearly signalled rate cuts next year. In the US, inflation stands at 3.1pc.
Economists fear the Bank of England is being over-zealous and risks tipping the UK economy into recession unnecessarily. The economy shrank unexpectedly in October as high borrowing costs hit activity.
Daniel Ivascyn, chief investment officer at Pimco, said earlier this week that Britain was at risk of an economic “hard landing” – a recession triggered by interest rates.
Analysts warn that Governor Bailey and his colleagues risk making a second major error in their inflation fight.
Initially, the Bank was too slow to raise interest rates when prices began to rise. Now, they are in danger of keeping rates too high for too long.
“The Bank misdiagnosed inflation and continues to misread the economy,” says Gerard Lyons, chief economic strategist at Netwealth. “Their policy mistakes could now lead us from inflation to recession.
“Monetary policy went from too loose for too long to now being too tight. It takes at least 12 months for higher interest rates to feed through fully and interest rates should have peaked at 4.5pc not at 5.25pc.
“Interest rates will need to fall in 2024.”
Suren Thiru, economics director at the Institute for Chartered Accountants in England and Wales (ICAEW), agrees: “Higher rates risk turning stagnation into recession as it could trigger a more severe spike in job losses.”
There are already signs that the job market is rapidly losing steam. Upward pressure on pay is fading. A rise in redundancies last month triggered the biggest increase in job seekers since lockdown, according to data from the KPMG and REC jobs report.
Businesses face a double squeeze from low consumer demand and high borrowing costs.
However, the Bank is concerned that the sharp fall in inflation could prove to be illusory. The November drop was partly driven by falls in petrol and food prices.
Policymakers have been worried about core inflation, which strips out these volatile categories and has been running far higher than the headline figure.
Still, core inflation cooled from 5.7pc to 5.1pc in November and has now “undershot the Bank of England’s forecast for the fifth month in a row,” points out Martin Beck, chief economic adviser to the EY Item Club.
The numbers will continue to confound the Bank’s forecasts, he believes. Oil and gas prices have fallen below the Bank’s forecasting assumptions. The pound has also strengthened, which will make imports more affordable.
“Inflation is likely to continue to fall faster than the central bank predicted,” says Beck.
There are still potential headwinds. Trade disruptions in the Red Sea have triggered a jump in oil prices and could push up the price of goods that are shipped through the Suez Canal. The price of Brent crude surpassed $80 per barrel on Wednesday, up $7 in just over a week.
A renewed rise in energy prices will complicate central bank decision making on interest rates, warns Torsten Slok, chief economist at Apollo Asset Management. “This is a risk to the Bank of England, a risk to the ECB and a risk to the Fed.”
But a repeat of the energy crisis seen last winter seems unlikely. Most economists believe we are through the eye of the storm when it comes to inflation.
The Bank came under heavy criticism for underestimating inflation in 2021. It attributed rising prices to transitory, supply-side shocks such as disruption to international trade caused by the pandemic and zero Covid policies in China.
Policymakers kept interest rates at a record low of 0.1pc up until December 2021, despite widespread expectations of an increase.
Bailey admitted this May that the Bank had “very big lessons” to learn about how it handles monetary policy during crises. After a request from the Treasury Select Committee, the Bank announced an external review of its forecasting in July, which will conclude in spring 2024.
Yet while Bailey and his colleagues now recognise their mistakes, Beck fears they have failed to learn the right lessons.
“They took fright at the criticism they got then and have now gone in the opposite direction and probably tightened too much.
“Their forecasts for a long time have shown inflation coming down to 2pc in two or three years’ time but they have kind of ignored that and focused too much on the latest data.”
Recognising the gulf between official messaging and the data, investors and traders are beginning to question the Bank’s credibility.
Despite Bailey and his colleagues insisting it is far too early to talk about interest rates, the City now sees a 50pc change of rate cuts by March.
Investors, the public and politicians face a long wait until the Bank’s next interest meetings in February, when we will find out who blinks first.
