If I had to pick one word to describe the Bank of England’s latest economic forecasts for the country over the next two years, it would have to be “bleak”. But are we heading for a recession?
The central bank is forecasting one of the longest recessions on record amid soaring prices and a decline in economic activity (thanks in part to higher interest rates, which it controls).
In the press conference following the central bank’s statement on interest rates yesterday, policymakers discussed their outlook for the economy, and the two scenarios they believe are most likely to play out over the next couple of years.
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Andrew Bailey, the governor of the Bank of England, had the unenviable job of explaining why forecasters are so downbeat.
He explained that there are “important differences between what the UK and Europe were facing in terms of shocks and what the US is experiencing,” noting that soaring energy prices are really the main reason why the economic outlook in Europe and the UK is so uncertain.
The Bank of England’s problem with inflation
Most of the challenges European nations are facing today can be traced back to energy costs.
Unlike the US, which, in 2019 produced more oil and natural gas than it consumed, Europe relies heavily on imports to meet its energy needs.
Even the UK, with its vast North Sea oil and gas reserves, only produces around half of its consumption – the majority of the remainder comes from Norway.
Russia’s decision to cut off its supplies to the region is forcing buyers to bid for gas on the open market where prices are far higher than the contracts for supply signed years ago.
What’s more, oil and gas are traded on international markets in dollars. Both the pound and the euro have fallen in value against the dollar over the past year by 16% and 14% respectively. That’s only adding fuel to the fire.
Higher energy costs affect every part of the economy. If a pub landlord is facing a 100% increase in heating costs, they have to put up prices for customers.
If customers are having to pay more, they will either cut back in other areas or try to earn more. If they are successful in earning more, they can spend more, which drives inflation.
And this is the challenge the Bank of England is facing today. Prices are rising and wages are growing. Granted, in real terms, wages are still shrinking overall, but some workers, particularly unionised workers, are winning double-digit pay increases.
Higher interest rates are designed to control inflation
The Bank of England is increasing interest rates to try and control inflation.
In theory, by increasing rates, consumers will save rather than spend, forcing businesses to fight harder for the remaining spending power. This may lead to lower prices (conversely, if the bank wants to stimulate demand, it can reduce interest rates, making borrowing more affordable and spending less attractive).
Under the Bank of England projections, if interest rates continue to rise and peak at 5.25% next year, inflation will fall back to 0% by 2025.
However, this will have a huge impact on economic activity. The economy could face the longest recession since the Second World War with eight quarters of economic contraction (the economy is officially in recession if it shrinks for two quarters a row). The unemployment rate could also rise to 6.4% in this scenario.
That’s one projection.
The Bank of England also laid out a more optimistic forecast, suggesting that if interest rates stay at the current level of 3%, inflation would fall to 2.2% in two years time and unemployment would rise, but only to 5.1%.
The economy would still contract, but the contraction would be mild by historical comparisons.
When Andrew Bailey was asked which scenario he thought was most likely to play out over the coming years. He said “where the truth is between the two, we’re not giving guidance on that.”
The Bank of England’s problem with unknown unknowns
Bailey’s statement was probably the most accurate part of the whole press conference.
Both of the Bank of England’s leading forecasts are almost certainly wrong because the outlook for the economy is so uncertain.
The central bank can only really control interest rates, which are a blunt tool. It has no control over the key driver of inflation today, energy prices.
It also has no control over the government spending and taxation plans, which are going to be announced in the budget on 17 November.
And this is where things start to get very complicated.
If the government decides it’s going to try and fill its £50bn fiscal hole by cutting spending and, as a result, reducing economic activity, this will have an impact on inflation and economic trajectory.
We also need guidance on the Energy Price Guarantee, a cornerstone of Liz Truss’ former government. The guarantee is now coming to an end in the first quarter of 2023, and the new chancellor, Jeremy Hunt, has promised it will be replaced by a “more targeted” support scheme.
Depending on how this support scheme is structured it could have a positive or negative impact on inflation projections and, as a result, the Bank of England’s interest rate decisions.
What do the Bank of England projections mean for your money?
Uncertainty is the name of the game right now, making it very difficult to say what the future holds for savers and investors.
Still, the governor did offer some guidance for borrowers saying “rates on new fixed rate mortgages should not need to rise as much as they have done recently.”
That’s because, while interest rates are probably going to increase from here, they are unlikely to hit the levels previously predicted by the market after the disastrous mini budget at the end of September.
Higher interest rates are also good news for savers, and if you haven’t shopped around to find a better deal for your money recently, now is the time to do so.
It could also be a good time to start thinking about fixing your savings as interest rates might not rise much further if the Bank of England’s more optimistic forecast (suggesting rates might not rise much higher than 3%) is to be believed.
For investors, uncertainty is the name of the game right now. Investors should be looking to protect capital first in this environment rather than chasing growth.
With interest rates on savings accounts now closing in on 5%, cash is starting to look like the more attractive option.
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