By Trevor Williams, former chief economist at Lloyds Bank
As expected, the Bank of England left interest rates on hold at its November quarterly meeting. Three members were still calling for rate hikes of 0.25% though the Bank of England lowered its forecast for GDP growth in 2024 from 0.5% to zero and its forecast for 2025 Q4 to just 0.4%. So, the Bank is now significantly more pessimistic about growth than just three months ago. Yet the vote for holding rates was six to three, meaning a lot of concern about inflation persists.
The Bank of England would not have lowered its growth forecasts lightly because next year will be an election year (though, theoretically, it could be held as late as January 2025). So, by implication, an election will be held in a year when the economy is not growing. That is a big political message to send. That is something one can be sure they would have wanted to avoid but felt they could not without compromising their views of where the economy is headed.
Moreover, the overall projection was that for the medium term (the next three years), the UK economy would grow by a meagre zero to 1%. That forecast is derived from their assumptions of slower growth in the working-age population and poor productivity, projecting the UK as a low-growth economy. One would have expected, therefore, lower inflation and interest rate forecasts as well over the next few years.
However, the official projection for inflation by the Bank was surprisingly pessimistic, assuming inflation would not fall to the 2% target until 2026. Using their assumption of the market estimate of the implied Bank rate (which they always use in their forecasts), the implication is that the rate would be 5.1% at the end of 2024, 4.5% at the end of 2025 and 4.2% at the end of 2026. These assumptions have been fed into its economic model and have, therefore, helped to keep economic growth lower than it would be otherwise.
That said, it is not just that these financial market assumptions underpin the banks’ economic forecasts. The Bank’s own underlying position, as shown by the vote and comments about interest rates remaining ‘higher for longer’ and that discussion of lower rates was ‘far too soon’ to be seriously debated, is also relatively hawkish.
Still, the financial market consensus is that interest rates have peaked in the major economies, with the US holding its key benchmark rate and the eurozone also doing the same. Around the world, consumer price inflation rates are declining from their peaks in 2022, albeit falling faster in some economies than in others. Unfortunately, the UK is among the countries where it’s falling more slowly. Annual consumer price inflation is 2.9% in the eurozone on average for October and 3.7% in the US, which compares with the UK’s current 6.7%. However, there is expected to be a fall to 5% or under when the UK’s October CPI inflation figures are released on November 15th, albeit still leaving its rates higher than its peers.
At the global level, price inflation is on the decline partly due to the fading of the supply side shock because Russia invaded Ukraine, which pushed up the level of prices around the world but is now beginning to unwind, as shown in the form of significantly lower gas, oil, fertiliser and food prices compared with their highs in 2022, and the rise in interest rates that took place.
With price inflation on the slide, it’s only a matter of time, perhaps as soon as in the first half of next year, that the pressure will rachet up on a range of central banks to start to cut interest rates to support economic activity. One factor weighing on price inflation for many countries, including the UK, is that only around 50% of the impact of the increase in interest rates so far has worked its way through the economy. That implies price inflation could fall more sharply worldwide in 2024 than expected.
Focusing on the UK’s growth, inflation, and interest rate profile, however, there is a particular risk of it revising official forecasts for the years ahead. In the year to September 2023, the UK’s broad measure of the quantity of money – M4x – fell by 4.2%. This is the sharpest fall since the series started in 1997. Even in 2008/9, during the global financial crisis, money supply growth did not turn negative.
That it’s turned negative now must be a warning sign that the risk of recession and an outright fall in inflation over the next three years is a growing one for the UK. The surge in money supply in 2021 to 15% heralded an inflation surge two years later. Although it was not the only cause of the inflation peak we saw last year, as already noted, it still contributed to it and is why the UK’s inflation rate is higher than other G7 economies.
Furthermore, the fall in M4 is also driven by the reversal of QE in the form of QT (the selling of government debt previously bought under QE) and not just interest rate increases. The Bank of England is selling £8.6bn a month, or the equivalent of £100bn over 12 months, of its stock of bonds bought under its QE programme. The implication of this is weaker economic activity than otherwise, as the cost of borrowing is higher and price inflation is lower, owing to the direct and indirect effects of slower activity and more expensive money. Unfortunately, the timing of when the effects of the fall in money supply impacts the economy is ‘long and varied’ – two to three years – so we cannot be more precise about when the effects will start to show up in growth and inflation.
However, if the fall in M4 is not reversed quickly, it will show up in a rapid deceleration in price inflation and slower economic growth from around late 2024 or early 2025 onward. In short, the implication for the Bank of England’s forecasts released on 2 November is that inflation and interest rates could be materially lower over the next few years than the current projections would seem to suggest. The risk is that these sharp deviations in broad money supply could lead to a swing from high inflation in 2022 to price deflation (falling prices) by 2026 if monetary policy stays unchanged, damaging growth and the monetary authorities’ credibility.
