UK economy walking an “unpleasant tight rope”

This leaves the policy makers walking a “very unpleasant tightrope” as they set monetary policy, according to Iain Barnes, head of portfolio management at Netwealth.

He was commenting in the context of the bank raising rates by 0.75 percentage points, to 3 per cent, a level not seen since 2008.

Particularly worrying for policy makers is the reaction of sterling, which fell sharply against the dollar today.

Typically, when rates rise, it should boost the value of the currency, as higher rates incentivise investors to hold the asset.

But Barnes said investors had expected a rate rise on today’s scale, but has been spooked by governor Andrew Bailey’s comment after the rates announcement, where he said the pace of future rate rises will be slower “than has been priced in by markets.

"The reason Bailey gave for this is that he does not feel the economy can handle a higher pace of rate rises.

But if the rates don’t rise, that causes inflation to persist, and inflation makes people poorer, and no central banker wants to do that. It is a very difficult tightrope.”

Luke Bartholomew, senior economist at Abrdn, elaborated on the nature of the “tightrope.”

In both cases, inflation undershoots its target towards the end of the forecasted period.Edward Park, Brooks Macdonald

He says: “Some aspects of the Bank’s forecasts are rather less informative than usual given the uncertainty over fiscal policy in general and energy policy in particular.

"However, the overall message is clear. The Bank thinks that if it were to deliver a rate hiking cycle in line with current expectations of investors, this would lead to a prolonged and deep downturn.

"So the Bank’s hope is that by hiking more today and in the near future, it will ultimately need to deliver less hikes."

According to Barnes, this is a "tricky message to communicate", and it remains to be seen how open markets are to it given the recent period of volatility and the Bank’s track-record of underestimating how much tightening it ultimately delivers.

Barnes said he believes bond markets have dealt with recent macroeconomic announcements in a “calmer” way than equity markets, as he feels the former had priced in a greater quantity of bad news.

Two scenarios

Edward Park, chief investment officer at Brooks Macdonald, said: “The Bank of England laid out two scenarios, one where rates rose to the 5.25 per cent expected by the market. In this case, the Bank forecasts a recession which would past two years.

"In the alternative scenario, where interest rates stayed at the new rate of 3 per cent, the Bank forecasts only 5 quarters of contraction.

"In both cases, inflation undershoots its target towards the end of the forecast period, this could mean the long awaited ‘pivot’ is coming into sight.”

He believes the UK is not really in control of its own inflation destiny as global factors will play a part. 

Oliver Jones, asset allocation strategist at Rathbones, says the Bank of England may have been trying to tell investors today that interest rates may peak at a lower level than has been priced into markets, but he is cautious.

According to Jones, the risk of inflation staying higher than the BoE expects remains significant, despite the government’s recent swing from fiscal expansion to contraction.

He says: "The BoE itself judges that the risks to its inflation projections are to the upside, with Governor Bailey in his press conference suggesting that these risks may be the largest in the history of the monetary policy committee.

"The labour market is still exceptionally tight.”

Supply weakness

Jones believes a key problem is the lasting weakness in supply since the pandemic, with hundreds of thousands of workers dropping out of the labour force, many due to long-term sickness.

With firms competing for a smaller pool of workers, wage growth has risen to 6 per cent, higher than the BoE previously forecast.

He explains: "The ratio of unfilled job vacancies to workers is also still exceptionally high, and the unemployment rate is near its lowest in half a century.

"Households’ and firms’ inflation expectations are also worryingly high. The Citi/YouGov measure of households’ long-term expectations remains above 4 per cent.

"And the BoE’s decision maker panel survey of businesses shows that they plan to keep increasing prices and wages at rapid rates (6.7 per cent and 5.9 per cent respectively) in the coming year.”

Inflation would usually be expected to fall during a period of prolonged recession as a result of the level of aggregate demand in the economy falling.

The ratio of unfilled job vacancies to workers is also still exceptionally high.Oliver Jones, Rathbones

Economies are comprised of supply curves and demand curves, inflation happens when the demand curve is steeper than the supply curve, ie that demand is rising faster than supply, while recessions happen when the supply curve is rising faster than the demand curve. 

Recessions reduce demand, causing suppliers in an economy to reduce supply, to match this, eventually this leads to the supply and demand curves tilting roughly in parallel. 

But much of the present inflation in the economy is focused on supply side factors which are less susceptible to demand declines, such as energy prices, meaning inflation and recession, a phenomenon known as stagflation, can happen at the same time. 

Barnes adds the outlook for UK inflation has not been materially changed by today’s Bank of England comments. 

He takes the view that equity markets remain too optimistic in their outlook, but sees value in high yield corporate bonds, rather than equities right now, on that basis.

david.thorpe@ft.com