What matters is the destination, not the journey

Ultimately, although a 25bps increase was voted through by a majority of six members, this split represents the highly uncertain economic environment currently complicating the Committee’s task of setting monetary policy for the UK. 

Life is full of (positive and negative) surprises

When the May inflation report for the UK was released, it surprised economists who expected both headline and core inflation measures to moderate. Instead, headline inflation remained unchanged from the previous month, with prices rising at an 8.7% annual rate. Meanwhile, core inflation, which excludes volatile energy and food prices, increased to a 7.1% annual rate – the highest since March 1992. The market reacted rapidly with expectations of peak UK interest rates rising to 6.5%, from 5.75% previously. This forced the BoE to increase the Bank Rate by 0.5%, compared to previous expectations for a 0.25% raise. 

As we highlighted previously, the latest UK inflation number for June surprised to the downside instead, showing that the annual rate of inflation has slowed to 7.9%. The level of surprise was smaller, but it was enough to scale expectations of peak rates back to 5.75% and allowed the BoE to proceed with a smaller 0.25% interest rate increase. 

Despite the volatile path, inflation data for June was in line with the BoE’s May forecast. In May’s Monetary Policy Report (MPR), the BoE forecasted inflation declining to 1.1% by the second quarter of 2025. In the August report released yesterday, this forecast was raised to 1.7%. Given that the general trend of inflation has been in line with expectations, it was interesting to see that the Committee has decided to revise their medium-term inflation forecast upwards quite materially. This is explained by stronger than expected wage growth which, in the Committee’s view, could lead to more persistent inflation on the services side. 

Nevertheless, the MPR remains positive on the near-term path for inflation, expecting it to decrease to 4.9% by the end of 2023.

As the Ofgem Energy Price Cap is adjusted, it is expected to reduce the annual rate of inflation by almost 1% in the July inflation report. Likewise, recent surveys indicate that grocery prices at UK retailers have been declining consistently over the last several weeks. The output producer price index (PPI), which measures change in factory prices for goods, has declined sharply and is now close to zero. Historically, PPI has a tight correlation with the consumer price index (CPI), but goods CPI remains elevated for now at a level of around 9%. Assuming the inflation data continues on a downward trajectory, this raises the risk of a monetary policy overshoot with policy remaining too tight for too long. Indeed, it appears that the Committee is cognisant of this risk and for the first time has described current policy as “restrictive”, arguing that it needs to remain “sufficiently restrictive for sufficiently long” to bring inflation back to target.

This was interpreted by some commentators as interest rates reaching the peak for the current tightening cycle, however the Committee declined to confirm it. Despite the positive near-term outlook, there are signs of some inflationary pressures reemerging, which complicates the outlook in the medium term. Oil prices have increased by over 10% in July due to the robustness of the global economy as well as Saudi Arabia’s output cuts. Prices of many food commodities, such as wheat, have also risen given the recent extreme weather events and Russia’s refusal to renew the Black Sea grain agreement. Although these will take some time to feed through into consumer inflation data, the path ahead can be expected to remain volatile.  

Navigating the ups and downs

Last week, we discussed how central bankers have moved away from providing forward guidance on interest rates, instead communicating that interest rates will be decided on a meeting by meeting basis. The BoE has likewise confirmed that it will remain data dependent and that, in their view, there is more than one path that leads to the target of 2% inflation. This message is understandable given the recent focus on the accuracy of their forecasts. The BoE acknowledged this in the press conference and provided a reasonable explanation, stressing that models only respond to data that resembles what they are trained on. A global pandemic and the first major land war in Europe since World War II is not included in the sample period. 

Outlining this in a more quantitative approach, BoE Governor Bailey showed that 

empirical models currently expect a rapid easing in private sector wage growth over the forecast period lasting to 2025.

The Committee members cannot be faulted for blindly following their models as in the latest MPR they have made a collective judgement call to assume that wage growth will persist longer relative to even the most aggressive model scenario, recognising that the current shocks facing the UK economy are highly unusual.

Ben Bernanke, the former Federal Reserve governor and the most recent laureate of the Nobel Prize in Economics, has been appointed to lead a review into forecasting at the BoE. The aim of this review is not to ‘fix’ the empirical models, but rather to review the broader approach to forecasting and monetary policy during times of significant uncertainty. 

The changing monetary policy transmission mechanism has introduced another factor that clouds the path forward for the Committee. The UK mortgage market has changed over the last decade as the number of variable rate mortgages has declined significantly; most mortgages are now on two- or five-year fixed deals. As a consequence, the passthrough mechanism to the housing sector has slowed down meaning that average mortgage rates are playing catch-up with the Bank Rate. This is reflective of the wider economy, where both consumers and businesses that are exposed to variable interest rates have faced difficulties whilst those with fixed-rate or limited debt have so far arguably only benefitted from rate rises through higher interest on savings accounts. 

The BoE will need to carefully balance weakening data and increasing stress in pockets of the economy against concerns of higher wage growth driving persistence in services inflation. However, the Committee was clear that they are determined to reach their goal of bringing inflation back to the 2% target.

Eyes on the target

The economy of a country responds in various ways to internal and external shocks, many of which can be unpredictable. Monetary policy is a tool used to smooth out the impact of these shocks. However, as the BoE is learning, the impact of monetary policy is not static either and changes over time depending on the composition and drivers of an economy. 

One aspect that remains constant is the price stability mandate, common to all major central banks in the world. It is therefore understandable that in the BoE’s view what matters most in central bank policy is not how the journey goes, but rather that the destination is reached successfully.