Access the Editor’s Digest at no cost
Roula Khalaf, Editor of the FT, handpicks her favorite stories for the weekly newsletter.
Here is a snippet from a recent discussion between Adam Posen — former member of the Bank of England Monetary Policy Committee and current president of the Peterson Institute for International Economics — and Bloomberg’s Odd Lots podcast hosts Joe Weisenthal and Tracy Alloway:
JW: I’m going to ask a somewhat random question, maybe you won’t want to answer. I’ll try to phrase it delicately. When we in America look at what’s happening in the UK, it always seems like a series of chaotic events with changes in leadership and bizarre scandals about random parties, etc., that I find puzzling. What do Americans need to understand about how the UK operates that we may be missing? As someone who served on the monetary policy committee, I read these headlines in The Telegraph, and I’m perplexed. What do I, as an American, need to know about the workings of England?
AP: I don’t think an American, or even an informed American investor, needs to know a lot about the UK.
JW: Well, that’s a straightforward response.
TA: That’s quite blunt.
Thankfully, one group that always finds the UK intriguing is UK economists.
Former MPC member Michael Saunders, now with Oxford Economics, has delved into the subject of rate cuts in a recent note, suggesting that the UK’s rate-cutting process could be faster than anticipated.
He notes:
— If the recent trends in wages and prices were the sole factors influencing monetary policy, the Monetary Policy Committee would likely aim to gradually reduce interest rates to a neutral level over the next 18-24 months. The MPC would probably consider this level to be around 3.25%-3.5%, with a margin of error on either side.
— However, the prospects of fiscal tightening and the diminished impact of the cash flow channel argue for a relatively swift return to a neutral monetary stance to prevent long-term inflation from falling below target.
Saunders highlights four key differences compared to previous rate-cutting cycles…
1) Core inflation remains elevated.
2) Fiscal policy is expected to tighten rather than provide support.
3) Monetary policy is exerting slower and smaller economic effects (largely due to mortgages)
4) There is greater uncertainty surrounding neutral rates
…and asserts (emphasis added):
While wage trends and core inflation suggest a gradual easing cycle, the possibility of significant fiscal tightening and prolonged monetary policy lags point in the opposite direction, supporting the argument for a substantial and front-loaded easing cycle. Unless interest rates decline significantly, the household cash flow channel will continue to impede growth in the next year or two as fixed-rate mortgages reset to higher levels. With fiscal policy expected to tighten significantly, overall economic growth may fall below potential in the coming years unless private spending sees a substantial increase. This is unlikely if monetary policy remains restrictive. Consequently, subpar economic growth would lead to increased slack and hint at below-target inflation in the future.
Given monetary policy lags and fiscal tightening, it is unlikely, in our view, that the MPC will wait until wage growth and service sector inflation reach target-consistent levels before making significant further interest rate cuts. If wage growth and service sector inflation are slowing as predicted, the MPC will place more emphasis on their forecasts that both will return to target-consistent levels in the next year or two.
These forecasts have been analyzed in a JPMorgan note released today. By examining the BoE’s move to cut rates, JPM’s Allan Monks and Morten Lund have developed backward- and forward-looking inflation measures based on MPC discussions on observed components. Here’s the breakdown:
They state:
The backward-looking indicator currently exceeds expectations by about one percentage point based on historical patterns. This raises the concern that a more lasting change has occurred in the inflation process, resulting in core inflation settling slightly above 3%. This is a worry for the BoE’s hawks, as highlighted in a recent scenario for inflation. It may simply be the case that the lags are slightly longer this time, possibly due to the unique circumstances of the pandemic. This would call for patience regarding disinflation and could support the case for an earlier or faster easing, aligning more with the doves’ argument.
This brings us back to Saunders, who suggests that while a rate cut in September seems highly improbable based on MPC language, various easing trajectories could be pursued, some potentially rapid.
Additionally, Saunders delivers a patriotic message to MPC members regarding the BoE’s relationship with its counterparts:
The likelihood of other major central banks also cutting rates as inflation risks for 2022-2023 diminish will likely prompt the MPC to follow suit. There is often an intellectual spillover where central banks feel more confident in their diagnosis and response when other central banks act similarly. However, unless the actions of other central banks or external factors lead to significant movements in sterling or other asset prices, the MPC’s focus will primarily be on domestic factors rather than external constraints. The MPC does not need to mirror the actions of other central banks.
He concludes:
Current market expectations suggest that the Bank Rate will drop to around 3.75% by the end of 2025 and remain around 3.5% thereafter. This end-2025 level appears reasonable and aligns with the OE forecast.
However, assuming credible fiscal tightening alongside slowing wage and core inflation, it is worth considering a scenario in which interest rates quickly return to a neutral level (approximately 3.25%-3.5%) within the next four or five quarters.
For more in-depth analysis:
— Insights into the UK economy