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A once-in-a century pandemic. War in Europe. A historic energy price surge. Andrew Bailey, the Bank of England governor, has been dealt some pretty rough waters in which to navigate monetary policy.
And now with the UK government borrowing tens of billions of pounds and the prospect of a global trade war on the horizon after the re-election of Donald Trump to the White House, things do not look as if they are going to get any easier.
The Bank will continue to provide its best assessment of the UK economy in its quarterly Monetary Policy Report, with the latest iteration released on Thursday.
The UK economy is expected to outperform expectations over the short term thanks to more government spending and investment set out in Rachel Reeves’s first budget.
Forecasters at the Bank said that GDP would expand by 1 per cent this year, slightly weaker than their previous assumption of 1.25 per cent. However, growth then picks up to 1.5 per cent next year and stabilises at 1.25 per cent in 2026 and 2027.
At their peak, the collective stimulative budget measures, including a £44 billion rise in day-to-day government spending and £20 billion per year of additional investment, would boost growth by 0.75 per cent, the Bank said.
However, inflation is poised to be higher than it would otherwise have been if the chancellor had not announced a £28 billion increase in annual government borrowing, among other budget measures. The Bank estimated that the policy package would raise inflation by around 0.5 percentage points at its peak effect.
Although Reeves offset some of the fiscal tightening set in motion by Jeremy Hunt, the previous Conservative chancellor, tax and spending is still on course to restrain economic activity from 2026.
This will help tame price rises, the Bank said. However, inflation will not drop to its 2 per cent target until 2027, slightly later than previously thought, peaking at 2.8 per cent in the third quarter of next year.
Forecasters at the Bank set out three scenarios for the UK economy: one where inflation “dissipates quickly”, a second where “a period of economic slack” is needed to tame price pressures and a third where inflation stays higher thanks to “structural shifts in wage and price-setting behaviour”.
The latest Monetary Policy Report is based on the second case, which also assumes that the UK economy is currently operating very near its capacity, a judgment shared by the Office for Budget Responsibility.
If this is true, then it means the economy is currently very susceptible to an inflationary shock if, suddenly, demand increases or supply contracts. As such, further government stimulus via more borrowing could intensify price rises, potentially leading to the Bank cutting interest rates more gradually.
Some £26 billion of Reeves’s £40 billion of tax rises in the budget comes from a 1.2 percentage point increase in employers’ national insurance contributions (NICs), taking the main rate to 15 per cent.
Economists have warned that the yield from this tax rise may fall to £16 billion thanks to employers lowering wages to offset higher tax payments.
The Bank seems to share this view, warning: “The increase in employer NICs is assumed to lead to a small decrease in potential supply over the forecast period. That reflects an assumption that employers will pass some of the rise in NICs through to wages, which results in slightly lower labour supply through reduced labour market participation.”
Some experts have suggested that the NICs increase could lead to higher inflation as businesses raise prices to shield their margins. The Bank downplayed this scenario, saying that it “will depend in part on the strength of demand in the economy as well as the competitive pressures they face. At present, the scope for such pass-through appears to be limited.”
The glaring problem with the Bank’s latest forecasts is that they use the market curve for interest rates for the week to October 29 — before the budget measures were announced.
Over the past week, UK government bond yields have risen markedly, with the rate on the 10-year gilt up by nearly 30 basis points, one of the largest increases after a fiscal event on record.
James Smith, developed markets economist at ING, the Dutch bank, advises that we should not to “read too much into the Bank of England’s latest forecasts”.
Similarly, Donald Trump’s victory in the US election could herald another era of trade friction. The incoming president has frequently said he intends to impose tariffs of up to 20 per cent on all imports and a steeper 60 per cent levy on Chinese goods. Trump is also likely to cut income and corporation taxes, expanding an already wide US fiscal deficit.
Under these conditions, global interest rates may stay higher, inflation may be stronger and growth may be weaker.
However, Bailey said in a press conference after the latest interest rate announcement: “We will wait and see.”