The Bank of England MPC meeting on 3rd February 2022 could turn out to be a watershed moment. For months now, the Bank of England has been dragging its heels on the matter of increasing interest rates. This is despite the growing upward momentum on inflation. However, this week’s meeting has seen a sharp policy change, with talk of further significant interest rate rises in the short to medium term. So what prompted the MPC to change tack and increase rates by 0.25%?
Prospects for the UK economy
In the short term, prospects for the UK economy are encouraging, with UK GDP hitting pre-Covid levels towards the end of 2021. While the Omicron variant is expected to have depressed December and January economic output, this should be a short-term phenomenon. Further improvement in GDP is expected in February and March, with the UK economy again hitting pre-Covid levels before the end of the first quarter.
However, there is no doubt that 2022 and 2023 will be tough times for households with disposable income under extreme pressure. The Bank of England believes that disposable incomes will fall by 2% during 2022 and a further 0.5% in 2023. This would be the most significant annual reduction in spending power since the 1990s and considerably impact consumer spending. It is important to note that a large portion of the pressure on household incomes results from high energy bills. However, many people believe that the Bank of England reacted too late to the overall threat of inflation.
The Bank of England now believes that UK economic growth will be just 3.75% in 2022, down on a recent forecast of 5%, falling to 1.25% in 2023, against November’s prediction of 1.5%. In addition, there is significant concern that an ongoing increase in interest rates, together with high inflation, could lead to further downgrades on economic growth. Inflation is running amock, storing up significant problems for the UK economy.
Unemployment in the UK
The latest Labour Force Survey confirmed that unemployment fell to 4.1% in the three months to November 2021. By the end of March 2022, this figure is expected to have fallen further to around 3.8%. With UK GDP growth forecast to slow to “subdued rates”, this will significantly impact unemployment. Excess supply in the UK economy is expected to hit around 1%, which will see unemployment hit 5%. The anticipated increase in unemployment will have a knock-on effect on consumer spending and company profitability. This, in turn, will reduce investment by businesses, also set to experience higher finance costs, and the vicious circle begins.
The recent relative strength of the UK employment market is reflected in earnings growth which is expected to hit 4.75% during 2022. While we know labour markets have been tight as the UK economy exits the pandemic, the relatively high inflation rate is starting to cause serious problems. The ongoing unwinding of an imbalance between supply and demand, together with a more subdued UK economy, will put a dampener on the UK employment market.
Inflation in the UK
The staggering about-turn by the MPC has caught many experts by surprise. We know from the meeting minutes that of the nine members, five voted for a 0.25% increase in base rates, but four members demanded a 0.5% rise. This is a consequence of the real and growing threat of prolonged inflation. Those who follow the MPC meetings will be aware that inflation forecasts have increased time and time again in recent months. With inflation rising from 5.1% in November to 5.4% in December, there were hopes that the worst was over. Unfortunately, this is not the case!
Even though the December inflation figure was approaching one percentage point higher than Bank of England expectations published in November, worse is to come. The Bank of England believes that UK inflation will hit circa 6% in February and March 2022. It is expected to peak at around 7.25% in April. At this point, the presumed ongoing interest rate rises will start to dampen consumer spending. So when will inflation start to fall?
As the UK economy moves towards a period of subdued economic growth, this will reduce the upward pressure on prices. To what degree remains to be seen with energy prices the primary catalyst for the worrying increase in the CPI figures. At this moment in time, there is likely to be more upward pressure on energy prices until long-term issues can be addressed. So, even with reduced consumer spending leading to weaker GDP growth, energy prices will still account for a massive element of household income.
That the MPC does not expect inflation to fall below the bank’s 2% target for at least three years is a worrying admission. After months and months of ignoring inflation, we may be about to feel the crippling impact on relative consumer income and spending.
UK interest rates
There continues to be intense speculation regarding UK interest rates in the short to medium-term. This week’s rise of 0.25% (to 0.5%) could have been worse, with some MPC members calling for a more significant increase. In what can only be described as a considerable U-turn by the MPC, we could now see UK base rates hit 1% by May 2022 and 1.5% in 2023. The MPC is stuck between a rock and a hard place. A significant increase in interest rates will decimate economic growth, while cheap finance will fuel inflation. Finally, it looks as though the MPC has decided to tackle inflation but at what cost?
Screeching U-turn damages MPC reputation
It is safe to say that the reputation of the Bank of England, and specifically the MPC, has come under intense pressure in recent years. This week’s screeching U-turn, while not wholly unexpected, has attracted the wrath of many experts. Time will tell whether a failure to tackle inflation earlier might exacerbate the fall in UK economic growth in the short to medium-term. Maybe things might have been different if the MPC had been more proactive with base rates last year?