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Bank of England walks monetary policy tightrope: inflation fears trump recession risk for now

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The Bank of England (BoE) raised interest rates for the third consecutive meeting last week, signalling to markets that taming inflation and containing second-round effects remains its priority. The Monetary Policy Committee (MPC) increased the base rate from 0.50% to 0.75%, resetting interest rates to pre-pandemic levels.

The annual rate of UK consumer price index (CPI) inflation reached a 30-year high of 6.2% in February, according to the Office for National Statistics (ONS). Inflation could peak around 8% in the spring, the BoE warned, fourfold the MPC’s 2% target.

Inflationary pressures are increasing from all sides – in higher energy, commodities and food prices, as well as raw materials, intermediate goods, labour and financing costs. The war in Ukraine is the latest in successive exogenous shocks that the UK economy has absorbed. The conflict will intensify inflationary forces over the coming months and increase an already uncertain economic outlook. A second energy-driven inflation spike is possible in the autumn, which could see CPI inflation briefly above 10%, given the UK’s vulnerability to higher energy prices, as a net importer.

At the same time, the legacy effects of the pandemic, and the ongoing issues with the UK’s trade deal with the EU, have collectively left the UK economy unbalanced. Rising cost pressures, higher corporation tax rates, sluggish demand for UK goods and services, and a weakening UK economic outlook all continue to weigh on firms’ investment plans. UK GDP is forecast to grow 3.6% in 2022, before slowing sharply in 2023 to 1.3%, according to the British Chambers of Commerce (BCC). These dynamics have tightened financial conditions for companies across the board. Households’ real incomes, corporate earnings and global supply chain bottlenecks remain under pressure. A recession is not inevitable, but the probability is rising. 

Forecasters expect the MPC to raise interest rates to between 1.5% and 2% by the end of the rate tightening cycle. The pace of future monetary tightening must balance inflationary headwinds with the danger of demand destruction. The trajectory will, in part, depend upon supply side resilience of the UK labour market, which was under pressure over the winter months. Increased demand for workers and contracted labour market supply prompted wage growth to accelerate. Employers added 275,000 jobs in February, according to the Office for National Statistics (ONS), rebounding strongly from the 60,000 jobs added in January, as Omicron weighed on recruitment. UK vacancies topped a record 1.3 million on the supply side, with record-high highs prevalent across industries. The UK jobless rate fell to 3.9% in the three months through January, back below pre-pandemic levels, ONS data shows. The growth rate in vacancies is slowing, but corporates continue to pay higher wages to retain and recruit staff. However, it is a mixed picture: nominal wage growth is higher in high paying sectors, while real wage growth suffers most in lower-paying occupations, exacerbating income inequality. The overall size of the workforce remains below pre-pandemic levels as older workers continue to leave the labour market.

UK SMEs will continue to be challenged by rising borrowing costs, which historically track the path of interest rates. This long-anticipated shift from stimulus to monetary tightening presents opportunities and risks for lenders and corporates  which require refinancing. As interest rates continue to rise, financing terms offered by banks will likely become more expensive. However, competition in the lending market, led by alternative lenders, will counter upward pricing pressure by offering greater flexibility on terms tailored to the borrower’s business needs. Moreover, expected increases in floating rate debt pricing may prompt borrowers to shop around to explore alternative financiers.

Borrowers must be mindful that existing debt can become more expensive to service, and there could be implications for the amount companies can comfortably borrow in refinancing requirements. Ultimately, rising financing costs can impact business profitability. These issues can create solvency concerns if financed assets suffer downward revaluations, as cash flows decrease and debt service costs rise. Higher base rates are likely to increase demand for fixed-rate loans and interest rate hedging products. Investment loan interest coverage ratios (ICRs) may also come under stress as the base rate rises.

At the macro level, the BoE’s could move from a position of quantitative easing to quantitative tapering (QT), where the rate of purchases of UK treasury bonds declines to the point of becoming outright sales. An accelerated QT programme could help dampen demand in the UK economy, cool some of the inflationary pressures, predominantly supply-side in nature, and prevent the need for as many rate increases. It is yet another reminder of the number of plausible outcomes for the UK economy that remain on the table.

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