BoE governor struggles with his messaging on monetary policy

Bank of England governor Andrew Bailey had a Herculean three-card trick to pull off on Thursday when presenting the central bank’s new inflation forecast and decision to hold back on immediately raising interest rates.

Bailey, who fuelled expectations of a rate rise last month by saying the BoE “will have to act” to tackle surging inflation, wanted those listening to accept three different messages — which to many in the audience may have appeared contradictory.

First, that the BoE Monetary Policy Committee is much more concerned about inflation than it was previously and interest rates really are going to rise “over coming months”.

Second, that it was good to wait and see before taking action because the outlook for economic growth had darkened and the overall picture was terribly uncertain.

And third that people should continue to heed his words even though he acknowledged that his comments last month about taming inflation had been “truisms” and therefore empty of meaning.

The BoE’s main forecast, based on market interest rates, showed inflation reaching 5 per cent next spring before coming back below the central bank’s 2 per cent target — indicating traders had become over excited about a tightening of monetary policy.

But Bailey said the MPC was more interested now in alternative predictions for inflation by the central bank that were based on the assumption that interest rates would remain at 0.1 per cent.

These predictions no longer suggested price stability in the medium term unlike the equivalents in the BoE’s May and August inflation forecasts, he added.

Line chart of CPI inflation with successive BoE 2021 forecasts (%) showing The BoE suggests prices will not be stable if it leaves rates unchanged

Instead, inflation was still at 2.8 per cent at the end of 2023 and “then you’ve got inflation stuck at around 2.6 [per cent]” until the middle of the decade, said Bailey.

He signalled the BoE’s alternative predictions for inflation “will require bank rate to rise”.

The BoE governor’s difficulty was that if rate rises were needed to control inflation, he also wanted to argue that they were not necessary now.

One ostensible reason for the MPC to wait at least until its December meeting was that its nine members would by then know whether the end of the government’s furlough scheme in September had led to job losses — and therefore would be in a better position to judge how far wage growth might fuel persistent inflation.

Bailey said the evolution of the labour market would be “crucial” to both the scale and the pace of interest rate rises.

However, the MPC’s monetary policy report made it clear the BoE is not expecting unemployment to increase much, with real-time data pointing to a tight labour market.

But even if the end of the furlough programme turns out to have gone smoothly, the MPC minutes of its November meeting and the monetary policy report highlighted other reasons for members to worry about the fragility of the UK’s economic recovery.

The real reason the BoE was unwilling to immediately raise interest rates was that it now expects gross domestic product growth to be weaker in the third and fourth quarters of 2021 than it forecast in August, with activity regaining its pre-pandemic level only in the first three months of 2022.

This is partly because of bottlenecks in supply chains, but also because higher inflation is already eating into households’ disposable income, thereby weighing on consumer confidence.

News charts showing: Real GDP

A majority of MPC members worried that “downside risks to demand could be accentuated by the impact of higher prices on households’ real incomes”. They noted households on low incomes planned to spend less in the coming months.

The majority of MPC members were worried more about choking off the economic recovery with a premature interest rate rise than they were about letting inflation take hold.

They noted there was very little scope to cut borrowing costs if the economy hit a roadblock, whereas “interest rates could be increased by as much as needed” if inflation looked likely to become entrenched.

Another uncertainty highlighted by the BoE was its concern that inflation might fall much faster than its own forecast suggests, adding to the risks around early rate rises.

This view stemmed, as BoE deputy governor Ben Broadbent explained, from an obscure convention in the way the central bank constructs its forecasts.

The BoE assumes wholesale energy prices evolve in line with market expectations for the first six months of the forecast period and remain flat thereafter.

But Broadbent said that because market expectations are for energy prices to fall rather than remain flat after six months, the latest inflation forecast might be too high.

Line chart of Per cent showing Market expectations for rate rises have fallen back sharply

David Page, economist at Axa Investment Managers, said the overall message on interest rates from BoE officials was they “have to act, but not quite yet”.

Many in financial markets, especially those traders who have been caught on the wrong side of a bet on immediate rate rises, were unconvinced by the BoE’s latest pronouncements.

Allan Monks, economist at JPMorgan, said Bailey’s comments over the past month had created “unnecessary market volatility”.

Kallum Pickering, economist at Berenberg Bank, said some of the BoE governor’s comments had been “very puzzling”, while Martin Beck of the EY Item Club called the guidance that rate rises would be needed in coming months a “vague formulation”.

On Thursday, however, financial markets roughly seemed to take in the BoE messages.

Many traders think the first interest rate rise will now come at the MPC’s December meeting, but are far from sure about this, with some betting on February.


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