Luke Bartholomew, senior economist, abrdn, looks ahead to this week’s Bank of England meeting.
The Chancellor’s decision to shift the timing of the next fiscal update to 17 November has taken some of the immediate economic significance off next week. However, even if the time between the government’s statement and the Bank of England’s meeting has been extended, there is still a delicate choreography between monetary and fiscal policy that needs executing.
It seems a big part of the reason that the government has delayed the fiscal statement is to give the OBR time to incorporate the recent fall of gilt yields into its forecasts. These lower borrower costs mechanically lower the size of the funding gap in the government’s fiscal plans, and so reduces the need for spending cuts and tax increases. This plan relies on gilt yields staying low over the next few weeks even as the Bank of England is likely to deliver a large Bank Rate increase.
We think an increase 0.75 percentage points is the minimum the Bank will deliver next week, and continue to think a 1 percentage point increase might be more appropriate. Key Bank policy makers have recently indicated they are uncomfortable with how high markets expect interest rates to increase, so the Bank may use the meeting to try to manage future interest rate expectations lower even as they tighten policy next week.
Certainly the rapidly deteriorating economic outlook will make it hard for the Bank to keep monetary policy as tight as markets currently expect. However, it remains to be seen how receptive investors are to this message right now after the recent period of volatility. It is possible a more dovish message from the Bank is interpreted by investors as a sign that the Bank is once again falling behind the curve on inflation.
Ironically, this might lead to another increase in gilt yields as investors anticipate greater inflation pressure in the future. And so a monetary policy strategy that is designed to try to lower future interest rate expectations may end up increasing them if policy is not seen as credible. The higher gilt yields in this scenario would also rebound against the government’s decision to delay its fiscal statement.
After a spike higher in October to around 10.5%, inflation should trend lower for the rest of the year. However, the government’s decision to scrap the energy price guarantee in April next year has complicated the inflation outlook for next year. Changes in wholesale energy prices will once again start to drive headline inflation through the Ofgem price cap. Recently we have seen wholesale gas prices trending lower, but should they move up again perhaps because of very cold winter or a further escalation of the geopolitical situation, this could easily see inflation back above the levels we have seen this winter.
The Bank of England will try to look through the volatility caused by the government’s policy and gas price movements, and focus on underlying inflation pressure. However, given the impact on household spending of such large inflationary moves, and the risk to inflation expectations, it adds a further complication to an already very difficult policy decision for the Bank.
So the UK’s fiscal/monetary nexus remains tight. Delaying the fiscal statement may have bought the government time and fiscal space, but it has also increased the period of uncertainty over how exactly the rapidly UK’s changing policy mix will play out.
[Main image: gez-xavier-mansfield-I_mkJxsx8kA-unsplash]
