BoE evaluation of economy show fewer inflationary pressures in long term

1.    The Bank of England’s Monetary Policy Committee voted to keep rates unchanged at 5.25% in February, as widely expected. However, the Bank no longer stated that further tightening may be needed, and one member of the MPC voted to cut rates by 25 basis points. Financial markets are not pricing in any further increase in Bank Rate, and expect three to four 0.25%pt cuts this year, and for it to fall to below 3.5% in five years’ time.

2.    CPI inflation increased by 4.0% in the 12 months to December, up from 3.9% in November, and the first time the rate has increased since February 2023. However core CPI increased by 5.1% - unchanged on the month. In the February Monetary Policy report published alongside the Bank Rate decision, the Bank forecasts CPI inflation to be 3.6% at the end of Q1 2024, down from their forecast of 4.4% in November 2023. Inflation is projected to fall temporarily to the 2% target in 2024 Q2 before increasing again in the second half of the year driven by developments in the energy markets. 

3.    The Bank do not expect Inflation to fall below target until 2027 due to the persistence of domestic inflationary pressures. Price inflation in the services sectors, while falling, is still over 6% in the UK. The OECD’s February Economic outlook says inflation across the G7 has fallen more quickly than anticipated and scope exists to lower policy interest rates as inflation declines further. However, the UK is expected to have the highest inflation amongst the G7 over the next two years.

4.    The Bank have also reviewed their evaluation of the supply and demand in the economy, to assess how fast the economy could grow without generating inflation. Supply growth is expected to rise over the next two years leaving it at around 1.3%, in line with its long run trend rate. They also no longer assume that lingering effects of the pandemic will weigh on productivity in the long term, with those industries most affected during the pandemic bouncing back more than expected. On the demand side, the Bank believe excess demand has now peaked and will fall to zero by the end of the year. The result of this review suggests that conditions in the economy are less inflationary than previously thought, and therefore could open the door to a rate cut.

5.    One significant contribution to the increase in supply is the bounce back in labour market participation. This has been driven by a decline in the number of people looking after family or the home, or due to retirement. However, partially offsetting this is the continued rise in the number of people stating they are not active due to long-term sickness, which began to pick up during the pandemic. 

6.    Labour market data is key for the MPC when setting rates and the ONS stopped publishing key data in September due to a drop in response rate making it unreliable. Since then the ONS have been publishing experimental figures, but recently published reweighted estimates incorporating the latest estimates of the size and composition of the UK population. Largely due to population recalculations the new data puts the unemployment rate at 3.9% compared to 4.2% in previous estimates. Despite this revision, the Bank say a range of evidence is pointing to an easing of tightness in the labour market, and the vacancies to unemployment ratio, fell further in November driven by 18 consecutive months of a fall in job vacancy numbers. The Bank expects the unemployment rate  to increase to nearer 5% over coming years.
 

7.    However, the Bank are unlikely to consider reducing rates they are clear inflation will be persistently lower over their forecast period, and the Bank believe further evidence of this process of weakening price pressure is required before cutting Bank Rate.