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Inflation could become an unlikely ally in the Bank of England’s fight against rising prices.
As paradoxical as it sounds, rocketing energy and commodity prices may be doing the work for monetary policy. Those forces will slow growth, and in the U.K. central bank’s estimation, help contain upward pressure on prices in the longer term.
That is the argument policy makers led by Governor Andrew Bailey have been making for several weeks now. It’s one reason why the BOE took a sharp increase in interest rates off the table and moderated its guidance about the path of policy at the March vote, when it raised borrowing costs by a quarter point to 0.75%.
Minutes to the meeting confirm a line of thinking that’s emerged in recent weeks, backed up by economists and research groups, that inflation can sow the seed of its own demise.
The idea is that the higher inflation rises, the more it squeezes living standards and lowers household spending power. By destroying demand, unemployment ticks higher and growth slows, leaving companies less able to boost prices.
By depressing demand for other goods, the energy price spike becomes dis-inflationary. As a result, interest rates need not rise so fast or so far, assuming that consumer inflation expectations are kept in check. The inflation snake ends up eating its own tail.
All that helps explain why the debate about whether the BOE should increase rates by half a point has melted away. Not one member of the committee vote for a super-sized rise this week, a big contrast with February when four people on the nine-member panel did. Deputy Governor Jon Cunliffe even voted to keep policy unchanged on Thursday.
“The bank, and Mr. Cunliffe in particular, is clearly very conscious that higher current inflation is doing the heavy lifting in reining in domestic demand and thus inflationary pressures — thereby capping inflation expectations in the medium term and reducing the need for the bank to move rates in anything more than a ‘modest’ way,” Nomura’s George Buckley and Jordan Rochester wrote in a note on Thursday.
The BOE’s current path is supported by Alex Brazier, a former senior official at the central bank now serving as deputy head of the BlackRock Investment Institute. He pointed out that the rapidly worsening inflation outlook is enough to throw up questions about the recovery both for the BOE and European Central Bank.
“Provided inflation expectations remain anchored the shock to demand brings down inflation later,” Brazier said. “The shock will have done the ECB and, to a degree the BOE’s, work for it.”
What Bloomberg Economics Says …
“The emphasis in the minutes on the real income squeeze suggests the Bank is going to let high near-term inflation do some of the heavy lifting required to cool demand. For it to work, inflation expectations will need to remain anchored – that may mean the Bank still sees a case for taking rates higher this year, but not to the levels markets expect.”
–Dan Hanson, Bloomberg Economics
The BOE made the same case in its February forecasts, which show inflation falling far below target if rates follow the market trajectory. The minutes to Thursday’s decision reinforced the point that rising prices will ultimately sap demand and bring down price gains.
“Inflation is expected to fall back materially, as energy prices stop rising and as the squeeze on real incomes and demand puts significant downward pressure on domestically generated inflation,” the BOE said on Thursday. “The impact on real aggregate income is … consistent with a weaker outlook for growth and unemployment.”
Central to the dilemma is what Silvana Tenreyro, an external member of the monetary policy committee, has spoken of as the trade-off between inflation and growth. The worse the cost–of-living gets, the more demand is destroyed, and the worse the economic hit.
The National Institute for Economic and Social Research already expects a recession in the U.K. in the final half of this year, due to weak consumer spending. It said the hit to growth should persuade “central banks to proceed carefully, but to signal that any delays in rate hikes are merely postponements, not cancellations.”
Similarly, Brazier says central banks still need to get rates quickly back to their “neutral level” — that is the point at which the economy is at full employment and inflation is stable. “When inflation is this high, it’s very difficult for central banks to have a policy that is stimulatory,” he said.
Neutral rates can change, however. In the euro area, the impact of the war in Ukraine is likely to push it down due to the energy price shock, Brazier said. As a result, the pressure to raise rates eases.
For the U.S. Federal Reserve and the BOE, tolerance for higher inflation does not mean they will dial back plans for higher borrowing costs. Instead, it will mean they do not need to overshoot the neutral rate to cool the economy.
“They will normalize policy to get back to neutral, but won’t need to hit the brakes,” Brazier said. “The Fed and the BOE can raise rates fairly swiftly. But there is now less risk of them having to go beyond the neutral rate to bring down inflation.”
The U.S. is engaged in a similar debate, but Jefferies LLC economists Aneta Markowska and Thomas Simons doubt whether soaring energy prices will do much to limit inflation in America.
“Had this shock occurred three years ago, the outcome would have almost certainly been dis-inflationary,” they wrote in a report to clients. “Today, we are leaning toward the latter scenario. Bottom line, second-order effects from higher commodity (prices) are not necessarily deflationary.”
Peter Chatwell, head of multi-asset strategy at Mizuho, is also skeptical. He thinks U.K. households will be resilient to the shock, and he fears inflation expectations could lurch out of control.
“We think this caution will force the BOE into more aggressive tightening in May and beyond,” Chatwell said. “While we do see the consumer suffering from higher energy bills, all other dimensions — really strong job security, large accumulated savings over the pandemic, etc. — will likely lead to resilient consumption.”