The rate of inflation remains on track to fall rapidly from the spring although there remains a risk of the UK’s tight labour market creating more inflationary pressures forcing the bank to intervene by rising interest rates, the Governor of the Bank of England has said.
On an official visit to South Wales, his last before the Bank’s Monetary Policy Committee makes its February decision on the base rate (currently 3.5%), Andrew Bailey said the central bank still believes the UK economy will enter into a recession which, although shallow, will be contracted.
He was not able to comment on where the bank sees interest rates peaking - with rate rises being its key weapon in reducing inflation and getting it back to its 2% target. But he noted that since taking the unusual step last November to comment that the market view on interest rates getting to a peak of 6% was too high, the bank hasn’t since made a similar intervention. The current market thinking on interest rates is that they could peak at around 4.5%.
In its Monetary Policy Report last November, the BoE expected inflation to fall to 5.2% in the Q4 of 2023 before dipping below its target of 2% in early 2024. Mr Bailey said that remains unchanged.
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Speaking at the manufacturing base of family-owned bakery firm Brace’s in Blackwood, Mr Bailey said the fall in the rate of inflation to 10.5% this month, following on from another slight decline in December was expected and was “the beginning of a sign that a corner has been turned.”
On the outlook for inflation said: “What we think is the most likely outcome is that it will fall quite rapidly this year, probably starting in the late spring and that has a lot to do with energy pricing.
“There was a sort of locked in level of energy prices over the winter, but we expect it to fall quite rapidly after that, for at least for a couple of reasons. One, it is a bit of arithmetic in the sense as it is of course an annual calculation so the big base effects from last year will start to fall out, And unless something happens, it will start to fall quite rapidly actually as we showed in our November monetary policy report.
“The other thing that has happened really in the last couple of months is that particularly energy prices have started to come off and gas prices quite a lot actually since the beginning of the winter. That isn’t actually yet feeding through, because of the way in which particularly domestic prices are calculated, but it will do. And that is encouraging and I think it is a product that Europe has higher stock levels and we had a warmer winter than we might have done. It does mean there is more optimism now that we are sort of going to get through the next year with an easier path there (inflation).”
On the risk side to inflation he said the Bank’s biggest focus is on how the labour market will evolve. He added: “We have had this quite unprecedented and quite unique fall in the labour force. If you compare it to pre-Covid to now, it is at least half a million actually. Unemployment has ticked up a little bit, but it is still at historically low levels, but we have had a rise in inactivity and the labour force has shrunk, and that is putting pressure on the labour market.
"I have been in South Wales talking to firms and get a lot of stories, as I do when we go to other parts of the country, that even though activity in the economy has been quite weak in recent times, the labour market remains very competitive and that is influencing pay negotiations.”
Interest rates
On the outlook for the base rate, Mr Bailey said: “We don’t target a particular peak, but what I will say is this, back in November, and quite unusually for us, we thought the market curve, and therefore the market’s view of what they thought we would do, was out of line with our own thinking. The reason was quite frankly there was still something which I would call a UK risk premium in there following the events of September and October (fallout from the Budget of Kwasi Kwarteng in Liz Truss’ short-lived premiership).
"If you go back to the height of that period, the peak of what the market thought we were going to get to was over 6%, but the time we did our forecast in November it was 5.2%, it is now down to 4.5%. Now I am not endorsing 4.5%, but what you may have noticed in December is that we did not include the comment that we made in November about the market being in our view rather out of line.”
The Economy
On the UK economy Mr Bailey said: “The level of activity we have in the economy is below where it was pre-Covid (GDP) and remains about 0.3% below. People always talk about the rapid recovery from the worst of Covid. The economy went off a cliff and it came back up some of the cliff, but since then it has been a pretty grinding process. That goes along with the fact that we have had a very big real income shock to the country, which obviously affects the situation. And working our way through that shock, and the inflationary impacts of that shock, is important. That is why I am afraid, and I know we have been marked down as a pessimist by saying, as we did in November, we think there will be a recession.
He added: “It has unfortunately got the characteristic of being long, but shallow. I would say that energy prices have come down so that ought to be a positive. We have lower gas and oil prices and that will help to alleviate that real income shock somewhat. The market interest rate curve has come down, the exchange rate has strengthened a bit which will help a bit in terms of its pass through to inflation. So,there are those contributing factors and we will have to do the analysis over the next couple of weeks (next monetary report) to see what we turn those into, but it is a pattern I would say unfortunately of weak activity over quite a prolonged period. When people talk about recession I understand it is quite a strong word to use, but it is a shallow one by historic standards.”
Mr Bailey said the reduction in the UK’s workforce since Covid, fuelled by EU nationals not returning, the impact of long Covid illness and early retirements, was not a uniquely UK problem. However, he said there was a British issue in the sense that other economies have experienced a return of people to the labour market.
He said: “I think a number of countries through the pronounced Covid period had a decline in their labour forces, but I think the UK is unique in not having corrected itself.”
With a post-Brexit red line from the Westminster Government on not increasing immigration to plug workplace staff shortages, it is now looking to encourage those who have left the labour market to return.
Mr Bailey said: “It is obviously not for us (comment on government immigration policy), but the government is very actively, and I think rightly, looking at how to encourage people to come back into the labour force and that would obviously be helpful.”
Asked if he recognised the UK Government’s argument that meeting public sector pay demands - where wage growth remains significantly lower than in the private sector - would in itself stoke inflation, he said: “Again that is not for us (to comment on).
However, he added: “But what I would say is if you look at wage settlements as a whole I have been concerned that we could get what we call second round effects, which is what we are most concerned about in terms of the impact and how we would have to raise interest rates as a consequence. The problem we are facing with this externally, in a sense imposed shock, which is causing inflation and a decline in national real income, is that of course people want to naturally keep up with it, but if the whole economy goes that way then we get more inflation and we would have to put interest rates up more to frankly cool it down.
“We watch the pay numbers very closely and for the whole economy. We are not distinguishing public and private sectors in how we approach monetary policy. At the moment I think the news on pay , yes there are some signs that if anything it is still rising a bit, but some of the forward looking surveys of earnings and pay are not as strong as that actually. So, we are extracting every piece of information that we can possibly find.”
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