If I had to choose one word to describe the Bank of England’s latest economic forecast for the country over the next two years, it would be ‘gloomy’. But are we headed for a recession?
The central bank is predicting one of the longest recessions on record amid soaring prices and declining economic activity (thanks in part to higher interest rates, which it controls).
At the news 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 unfold. over the next two years.
Andrew Bailey, the Governor of the Bank of England, has had the unenviable task of explaining why forecasters are so pessimistic.
He explained that there are “significant differences between what the UK and Europe were facing in terms of shocks and what the US is going through”, 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 facing European nations today can be attributed to energy costs.
Unlike the United States, 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 reserves of oil and gas in the North Sea, produces only around half of its consumption – the majority of the rest comes from Norway.
Russia’s decision to cut supplies to the region is forcing buyers to bid for gas on the open market where prices are far higher than supply contracts signed years ago.
In addition, oil and gas are traded on international markets in dollars. The pound and the euro have depreciated against the dollar over the past year by 16% and 14% respectively. It just adds fuel to the fire.
Higher energy costs affect all sectors of the economy. If a pub owner faces a 100% increase in heating costs, they must raise prices for customers.
If customers have to pay more, they will reduce spending in other areas or try to earn more. If they manage to earn more, they can spend more, which fuels inflation.
And that is the challenge facing the Bank of England today. Prices rise and wages rise. Yes, in real terms, wages continue to decline overall, but some workers, especially unionized workers, are getting double-digit wage increases.
Higher interest rates are designed to control inflation
The Bank of England raises interest rates to try to control inflation.
In theory, by raising rates, consumers will save rather than spend, forcing businesses to fight harder for remaining purchasing power. This can 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).
According to 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 World War II with eight quarters of economic contraction (the economy is officially in recession if it contracts two quarters in a row). The unemployment rate could also climb to 6.4% in this scenario.
It’s a projection.
The Bank of England also presented a more optimistic forecast, suggesting that if interest rates remained at the current level of 3%, inflation would fall to 2.2% in two years 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 what scenario he thinks is most likely to unfold in the years to come. He said “where the truth is in between, we don’t give guidance on that.”
The Bank of England’s Problem with Unknown Unknowns
Bailey’s statement was probably the most accurate part of the entire press conference.
The Bank of England’s two main forecasts are almost certainly wrong because the economic outlook is so uncertain.
The central bank can only really control interest rates, which are a blunt tool. He has no control over the main driver of inflation today, energy prices.
He also has no control over government spending and tax plans, which will be announced in the November 17 budget.
And this is where things start to get complicated.
If the government decides it is going to try to plug its £50billion budget hole by cutting spending and therefore reducing economic activity, that will have an impact on inflation and the economic trajectory.
We also need advice on energy price guarantees, a cornerstone of the former Liz Truss government. The guarantee now expires in the first quarter of 2023, and new Chancellor Jeremy Hunt has promised it will be replaced by a “more targeted” support scheme.
Depending on how this support regime is structured, it could have a positive or negative impact on inflation projections and, therefore, on the Bank of England’s interest rate decisions.
What do the Bank of England’s projections mean for your money?
Uncertainty is the name of the game right now, making it very difficult to tell what the future holds for savers and investors.
Still, the governor offered some advice for borrowers, saying “rates on new fixed-rate mortgages shouldn’t need to rise as much as they have recently.”
Indeed, while interest rates are likely to rise from here, they are unlikely to reach 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 been looking to find a better deal for your money lately, now is the time to do so.
It could also be a good time to start thinking about securing your savings, as interest rates may not rise much more if the Bank of England’s more optimistic forecasts are to be believed (suggesting that rates could not increase much more than 3%).
For investors, uncertainty is the name of the game right now. Investors should primarily seek to protect their capital in this environment rather than seeking growth.
With interest rates on savings accounts now approaching 5%, cash is starting to look like the most attractive option.