In Its Biggest Interest Rate Hike In 27 Years, The Bank Of England Predicts A Prolonged Recession

In Its Biggest Interest Rate Hike In 27 Years, The Bank Of England Predicts A Prolonged Recession

This week, the Bank of England raised interest rates by 50 basis points, its most significant single increase since 1995, and forecasted the longest recession the country has seen since the global financial crisis began.

As a result of the sixth consecutive increase, borrowing costs have reached 1.75% for the first time since the Bank of England became independent from the British government in 1997.

There was a majority vote of 8-1 in favor of the historic half-point increase by the Monetary Policy Committee. In its statement, the Bank of England cited the increasing pressure on inflation in the United Kingdom and the rest of Europe since its previous meeting in May of this year.

“This is largely a result of the near-doubling of wholesale gas prices since May, due to Russia’s restriction of gas supplies to Europe, as well as the possibility of further curbs,” the MPC said in a statement that accompanied its report.

“Because of the way in which this feeds through to retail energy prices, this will exacerbate the fall in real incomes for UK households in the near term and will further increase inflation in the UK’s Consumer Price Index.”

It is anticipated that Britain’s energy regulator, Ofgem, will increase the energy price cap by 54% from April to accommodate soaring global costs, although the increase is expected to be even greater in October, with annual household energy bills expected to exceed £3,600 ($4,396).

As of right now, the Bank of England expects headline inflation to peak at 13.3% in October and to remain elevated throughout much of 2023 before falling to its target of 2% in 2025.

In Its Biggest Interest Rate Hike In 27 Years, The Bank Of England Predicts A Prolonged Recession

Moreover, the MPC noted that the labor market is still tight and that domestic cost and price pressures remain elevated, which adds that there is a risk that a “longer period of externally generated price inflation will lead to more enduring pressures on domestic prices and wages.”

Despite the tight labor market, the unemployment rate remained at 3.8% in the three months to May and the number of vacancies was at historically high levels, according to the MPC.

Accordingly, and consistent with the latest Agents’ survey, underlying nominal wage growth is expected to be higher than the level forecast in the May Report over the first half of the forecast period.

Following the Bank of England’s announcement, sterling fell over 0.5% against the dollar, trading at around $1.209, while the FTSE 100 index climbed 0.5%.

Cost-of-living crisis

According to Bank of England Governor Andrew Bailey, the shock of Russia’s war in Ukraine is now the largest contributor to U.K. inflation “somehow.”

“The war has an economic cost, but we will not let it deter us from setting monetary policy to bring inflation back to 2%,” he said.

At the August meeting, markets priced in a more aggressive approach after food and energy prices continued to rise, deepening the country’s historic cost-of-living crisis.

Last month, Bailey vowed that the central bank would commit to returning inflation to its 2% target “without any ifs or buts.”

A long recession begins later this year, according to the Bank, and inflation will peak even higher than expected later in the year, according to the Bank. A toxic economic combination like this would be extremely difficult for the central bank to navigate even at the best of times, let alone when it is increasingly being forced into the spotlight by political forces.

A number of analysts had been keen to assess the bank’s language, particularly its previous commitment to act “forcefully” on inflation, and the MPC retained the language in its report on Thursday that was particularly welcome to analysts.

Bailey said, “I am well aware of the significant impact that this will have, and the fact that the cost-of-living challenge will continue to be a challenge for many people in the United Kingdom for some time to come.”

The least well-off are the ones who suffer the most from inflation, but if we do nothing to prevent inflation from becoming persistent, the consequences later will be worse, and that will require us to increase interest rates more aggressively.

According to the bank, it intends to start active government bond sales worth approximately £10 billion ($12.1 billion) per quarter beginning in September, provided that policymakers give their final approval for such sales.

Recession incoming

As a result of the latest gas price rise, the bank issued a grim outlook for economic growth for the next few quarters, suggesting that the latest gas price hike has led to another “significant deterioration” in the outlook for the UK economy as the rest of Europe.

The MPC has now projected that the U.K. economy is expected to enter into a recession from the fourth quarter of 2022 and that the recession will last for five quarters, as real household post-tax income falls sharply in 2022 and 2023, and consumer spending begins to contract.

In terms of historical standards, the growth that followed was fragile. I believe that the contraction of output and the weak growth outlook beyond that is mainly due to the significant adverse impact that sharp increases in global energy and tradable goods prices have had on U.K. real household incomes,” the MPC wrote in its report on monetary policy.

There is an expectation of a 2.1% drop in output from peak to trough when the economy will begin to contract in the fourth quarter of 2022, and the contraction will continue through the year 2023.

According to Luke Bartholomew, senior economist at the Abrdn, the bank’s forecasts make it very clear that the U.K.’s economic picture is difficult compared to that of other major countries in the world.

“The Bank of England is predicting a very long recession starting later this year, as well as an even higher peak in inflation at the end of the year. There is no doubt that this is a toxic economic combination, which the central bank would find difficult to navigate even at the best of times, never mind when it is increasingly thrust into the political spotlight, he continued.

According to reports, Liz Truss, who is expected to win the Conservative Party leadership contest and succeed Boris Johnson as prime minister if she wins, is considering reviewing the Bank of England’s inflation mandate and the extent to which it is independent of the central government.

Taking into account that inflation is now expected to stick around for a longer period of time, it is difficult to see how the Bank will be able to pivot towards supporting the economy any time soon. As a consequence, investors should expect further interest rate increases from here on, even if markets and the economy are struggling,” said Bartholomew.