Stagflation looms for UK economy – POLITICO

The pound had its worst day in two years Thursday after the Bank of England admitted what every central bank hates to admit: Some problems are just too big for them to solve.

The Bank bleakly warned that it’s “unable to prevent” a fall in profit margins and in household incomes due to the huge rise in energy prices. But it conceded it had to add to the pain with higher rates to stop a destructive wage-price spiral from forming.

The Bank’s report illustrated what private-sector analysts and Governor Andrew Bailey have been admitting for some time now: The UK combines the worst parts of the outlook for the US and eurozone economies, with consumer spending power hobbled by rampant inflation and a labor market suffering intense shortages of human capital.

The Bank raised its key interest rate for the fourth meeting in a row, by 0.25 percent, taking it to a 13-year high of 1 percent. But the expected slowdown in the economy — already visible in plummeting consumer confidence and falling retail sales numbers — means that the end of monetary policy tightening may already be in sight, analysts said.

“The meeting’s cautious tone and a dovish set of new forecasts suggest the Bank’s tightening cycle will be much less aggressive,” said ING analyst James Smith in a note to clients. “We expect another rate hike in June and probably one more in August, before the committee presses the pause button.”

In its regular update, the Bank cut its growth forecasts for the next couple of years and said the economy will contract in the summer before rebounding weakly thereafter. Unemployment, meanwhile, is set to rise to 5.5 percent within three years, from 3.8 percent currently.

At the same time, the BoE now sees inflation peaking at over 10 percent in the fourth quarter of this year, as increases in world energy prices force regulator Ofgem to lift the cap on household bills again. Deputy Governor Ben Broadbent told journalists at the Bank’s press conference that this “external” shock accounted for 80 percent of the inflation overshoot.

High energy prices, the Bank noted, “will necessarily weigh further on most UK households’ real incomes and many UK companies’ profit margins.”

The worst-of-both-worlds outlook was reflected in deep divisions within the nine-strong Monetary Policy Council. Some urged tougher action on inflation now while others thought it inappropriate to warn that further interest rate rises may still be needed. Three of the nine voted for a half-point rise in the bank rate, in parallel with the US Federal Reserve’s decision on Wednesday.

Such divisions may present acute difficulties for the Bank in communicating its policy in the next few months. But it did appear reasonably prepared for criticism that it’s adding to the swelling cost-of-living crisis by raising borrowing costs.

“We are worried about second-round effects,” Bailey said, warning that “it’s those with least bargaining power that will suffer most” if wages and prices start to chase each other higher.

Growth in average earnings, including bonuses, accelerated to 5.4 percent in March, above what the Bank considers compatible with its 2 percent inflation target.

market slump

Financial markets took the news badly. Sterling, which has been under pressure since the International Monetary Fund downgraded its forecasts for the UK economy last month, fell nearly 3 cents against a resurgent dollar to below $1.2350 as foreign exchange traders priced in a widening interest rate differential with the US

In contrast to the BoE, Fed Chair Jerome Powell had reported on Wednesday that a string of half-point increases in US rates was likely, sharply increasing the relative attractiveness of holding dollars. Against the euro, too, the pound loss nearly 1.5 cents.

In the bond markets, UK government bond yields fell sharply, before being dragged higher by US bonds later in the session.

The more pessimistic growth outlook means that the Bank is almost certain not to begin selling the pile of government debt that it acquired during the pandemic for at least another four months. Staff will present draft proposals for active bond sales to the MPC’s meeting in August. Actual sales are unlikely to start before September.

In a separate market notice, the Bank said it will start selling down its £20 billion corporate bond portfolio at the same time, aiming to complete the process by early 2024 at the latest.

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