Once upon a time, the Bank of England raising interest rates was a signal that the economy was performing well. After all, if the Monetary Policy Committee believed that the economy needed to be cooled, then at least some people were probably enjoying the heat. Reading the minutes of today’s MPC deliberations though, it is hard to find the positives.
The downbeat tone is fully understandable given the energy price and food price inflationary shock emanating from the war in Ukraine.
As the MPC note, the spot price of Brent crude has risen by 17% since their February meeting. Mostly because of energy prices, the Bank’s view on inflation in the coming months has been notched up:
CPI inflation was expected to rise to around 6% in February and March, before rising further, to around 8% in April, and remaining close to that rate for the rest of the quarter. The latter would be around 1 percentage point higher than expected in the February Report.
And, whilst gas prices have been volatile, the MPC noted that they are currently pointing to a much higher than expected rise in the retail price cap this Autumn:
Wholesale gas prices had been exceptionally volatile and the six-month observation window relevant for Ofgem’s October utility price cap calculation, which would run from February to the end of July, had only recently opened. If sustained, the latest rise in gas and electricity futures prices would mean that price caps, when reset in October 2022, could be around 35% higher, which would be around 20% higher than had been expected in the February Report.
All of which adds up to a large hit to real household disposable income.
Prior to the invasion in late February, there had already been tentative signs that the squeeze on real disposable incomes was starting to weigh on the household sector. Although aggregate retail sales volumes had risen strongly in January, food sales had fallen to below pre-pandemic levels as food prices had risen. Notably, GfK consumer confidence had declined materially in February, with the weakness most pronounced in the forward-looking personal financial situation component. It was, however, unclear whether that represented downside news relative to the weakness in real incomes and spending that had been factored into the February Report projections. Intelligence from the Bank’s Agents suggested that consumer spending had continued to grow at a robust pace. However, contacts were concerned about the outlook for demand over the coming months, due to increasing pressures on households’ real disposable incomes.
As the minutes alluded to, how households react to a fall in their real incomes is the big question for the UK macroeconomy this year.
Some analysts have taken solace in the ability of the large stock of household savings built up during the pandemic to act as a shock absorber, potentially smoothing the hit. But as the MPC carefully set, the distribution of those savings doe not tally at all well with the distributional hit coming from higher energy bills.
The extent to which households reacted to the additional weakness in their real incomes by cutting their real spending or by reducing their savings would be important to monitor over coming quarters... Developments in energy prices were likely to affect disproportionately households with lower incomes. Those households had not in general seen substantial rises in savings during the pandemic, however, which would limit the extent of any offset from a rundown of savings.
An awful lot has changed since the MPC last met: inflation is heading higher, growth looks set to be weaker, the squeeze on household income is going to be larger and financial conditions have materially tightened. Amid all this bad news, it is perhaps no surprise that the tone of the minutes is much more dovish than those of February.
The hike to 0.75% was passed with a vote of 8-1 rather than the expected unanimous result. And whilst reading too much into voting splits is always a mistake, the language around future policy has also loosened. The committee now “judges that some modest tightening in monetary policy might be appropriate in the coming months” (my emphasis). Last month’s minutes, by contrast, stated that “some further modest tightening in monetary policy is likely to be appropriate in the coming months”.
After four members voted to hike by 0.50% rather than 0.25% last month, it was hard to see the MPC doing anything other than raising rates to 0.75% today. But it has the feel of a body simply going through the motions. Today’s hike leaves the key policy rate back where it was when the pandemic hit.
In the weeks since the last MPC meeting the economic fallout from Russia’s invasion of Ukraine has already delivered tighter financial conditions and a bigger hit to household incomes than any modest policy adjustments from the Bank. Something the MPC themselves recognise:
Further out, inflation was expected to fall back materially, and possibly to a greater extent than had been expected in the February Report, as energy prices stopped rising and as the squeeze on real incomes and demand put significant downward pressure on domestically generated inflation. The recent increase in the market-implied path of Bank Rate would also push down on demand and inflation in the medium term relative to the February Report, all else equal. (My emphasis)
In other words, higher inflation now – as energy prices rise – may well mean lower inflation in the future (a logic not unfamiliar to Value Added subscribers), and could well even mean that rates peak at a lower level than currently expected.
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