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Last Thursday the Bank of England resolved the hottest debate in economics, warning that the UK would fall into a recession later this year. As central bank announcements go, this was a bombshell. Never in the 30 odd years that I have been following the Bank has it produced a growth forecast that is so much weaker than market forecasts. Until last Thursday all but two of the 27 forecasters surveyed by the publication Consensus Economics were forecasting that the UK economy would expand next year. With its forecast of a 1.5% contraction in GDP in 2023, and a five-quarter recession, the Bank has rewritten the future, warning we are heading for a downturn on the scale of the 1990-92 recession.
This is a watershed moment. 99% of economic forecasters are spectators. The Bank sets monetary policy and has a massive influence on the path of growth. It has become markedly more worried about the breadth and persistence of inflation and is warning that it will take a recession to bring inflation back to its 2.0% target.
Sharp rises in energy prices, particularly the gas price, and a fall in the value of the pound, explain most of the increase in the Bank’s latest forecasts for inflation. But the Bank seems even more concerned that companies are raising prices and that labour shortages have become endemic. As the Bank’s governor, Andrew Bailey, put it last week, “The first thing that businesses want to talk to me about is the problems they're having hiring people....They're also saying… they're not finding it difficult to raise prices….That can't go on."
The Bank thinks that the economy is overheating, with demand exceeding supply this year by a sizeable margin. The worry is that today’s inflation, fuelled by the pandemic, supply chain disruption and the war in Ukraine, risks becoming embedded. Despite the gathering economic gloom, businesses are able to pass on costs and are stepping up hiring. A Bank survey shows businesses planning to increase headcount by more than 4.0% in the next 12 months, a faster increase than in the last 12 months. In the absence of labour shortages, companies say they would have liked to increase their headcount by 7.0%. This hardly suggests a lack of confidence.
The message from Mr Bailey is that the economy is growing too fast and that activity needs to slow sharply. It is a warning, and an attempt to reset expectations. Consumer confidence was already at record lows before last week’s news from the Bank. With unemployment set to rise next year, higher credit costs feeding through, and the income squeeze set to intensify, consumer confidence is likely to hit new lows. Business confidence has proved more resilient but, with a recession looming, that is unlikely to last. UK equities have fallen only 5% from the peak seen this January when the global economy and the UK looked set fair for a healthy recovery. Despite the prospect of recession and of higher interest rates investors remain pretty keen on UK equities.
The Bank’s new forecasts show inflation, which is currently 9.4%, peaking at 13% in the fourth quarter of this year as energy bills rise by 75% with the reset of the price cap. The inflation rate then eases slightly, to 9.4% by the third quarter of 2023 but only drops down to the 2.0% target in the third quarter of 2024. On these forecasts, the overall price level will rise by 25% in three years, between January 2021 and December 2023.
Interest rates have risen from last December’s low of 0.15% to 1.75% today. We see the Bank increasing them by a further 175 basis points, taking them to a peak of 3.5% by the middle of 2023. From September, the Bank is likely to start the process of quantitative tightening, selling down its stock of government bonds, adding to the tightening of monetary policy. The Bank will be reluctant to cut rates until it sees a pronounced weakening of headline inflation and wider wage and price pressures - conditions that may only emerge in the latter part of next year.
The last few months provide ample illustration of the fallibility of economic forecasts. What looked like a solid recovery six months ago appears to be turning into an inflation-driven recession. Yet the Bank’s latest forecasts are a point in time view – it’s not hard to think of things that could change them.
One way in which the future could deviate from the Bank’s latest view would be if pricing pressures respond more quickly than it expects, with the jobs markets weakening in the coming months, corporate pricing power dissipating and transient drivers of inflation fading. Greater weakness now would mean a lower peak in inflation, and interest rates, and stronger growth further out. That’s the happiest outcome for the economy but it’s not one the Bank expects.
We can be sure that government policy will shift with the arrival of a new prime minister in Downing Street in September. Both candidates for the leadership, but particularly Liz Truss, have talked of cutting taxes to counter the cost-of-living crisis. The government announced a £15bn Cost-of-Living Support package in May, focussed on helping lower income households. Ms Truss rejects further such ‘handouts’, instead promising a further £30bn of tax cuts, funded by higher borrowing. One of her supporters, the business secretary, Kwasi Kwarteng, argued last week that as monetary policy tightens, the government should ease fiscal policy.
The UK economy has weathered two exceptionally deep recessions in the last 15 years. The Bank is forecasting something milder, involving a contraction in GDP of just over 2.0%, compared with a 6.0% contraction in the financial crisis of 2008-09 and a record-setting 22% contraction in the pandemic. We can take scant consolation from the comparison. A 2.0% contraction in GDP would be in same category of severity as the UK recession of 1990-92 that caused significant disruption. This time, the downturn will be driven by a major squeeze on consumer spending power and, on the Bank’s forecasts, is likely to lead to a marked rise in unemployment. A mild recession by the standards of the last two will feel anything but mild.