The Bank of England balances delicately

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In anticipation of the Bank of England’s 14th consecutive rate rise since 2021, Prime Minister Rishi Sunak expressed optimism about Britain’s inflation battle, stating that “there is light at the end of the tunnel.” After facing criticism for falling behind in addressing the country’s high inflation compared to other G7 nations, the UK is finally seeing a downward trajectory in price growth. Following a substantial 50 basis point rate rise in June, which reflected earlier complacency, inflation data has started to cool. In August, the Monetary Policy Committee opted for a less aggressive 25 basis point rise, bringing rates to 5.25%. However, there seems to be uncertainty regarding the next steps.

The mixed signals from the meeting are particularly worrisome given the current strain on the economy and the potential risk of triggering a recession. The MPC’s acknowledgment that persistent inflationary pressures may be solidifying suggests the need for a tight policy. However, the guidance that rates will remain “sufficiently restrictive for sufficiently long,” along with a split vote, with two members advocating for a more forceful 50 basis point rise, indicates uncertainty about the extent and speed of the BoE’s actions.

A 25 basis point increase this month was a sensible decision. Broader price pressures are subsiding, with food price inflation reaching its lowest point in a year. Producer price inflation, a leading indicator of consumer prices, has also decreased significantly. Previous rate rises have reduced demand. Last month, annual house prices experienced their sharpest decline since 2009 due to higher mortgage rates. Bank lending has eased as well. However, the job market remains a challenge for the MPC, with wages continuing to grow strongly.

The UK’s robust labor market has kept core inflation, which excludes energy and food prices, at an elevated level of 6.9%. Some tightening measures are likely necessary. However, the modeling that showed the BoE reaching its 2% inflation target by 2025 under various interest rate scenarios has caused confusion. Some view the August meeting as “hawkish,” while others emphasize “dovish” tones, highlighting the central bank’s communication challenges.

The way the BoE proceeds is crucial. Home buyers and those planning to remortgage already face higher annual payments, which could limit demand. Business activity is also declining rapidly. If the BoE is too cautious, there is a risk that persistent inflation influences wage resilience. On the other hand, pushing rates too high and for too long could harm the economy.

Part of the problem stems from the difficulty of accurately assessing the impact of previous rate rises on the economy. Few central banks have successfully tackled this issue. Even the MPC itself, as admitted by Governor Andrew Bailey, does not heavily rely on its own internal model. The planned review by former Federal Reserve Chair Ben Bernanke is highly anticipated, as it could improve the BoE’s processes.

For now, the BoE must proceed cautiously and closely monitor the data. While it previously played catch-up, the current state of the economy is more delicate, and price pressures are easing. Adopting a slow and steady approach from this point forward would be wise in order to gain a clearer understanding of the economy’s situation.

Britain was the first major advanced economy to raise rates but the last to overcome double-digit inflation. The BoE surely does not want to be the last to recover from a substantial recession caused by interest rate hikes. The light at the end of the tunnel should not lead to a setback.