How can the BoE get its forecasting so very wrong?

The Bank of England followed the Federal Reserve and the European Central Bank in raising its base interest rate by 0.25% to 4.5%. While it appears, the Fed is pausing its interest rate hiking cycle, the BoE and ECB could still have some work to do.

Governor Andrew Bailey had to accept that it is now likely to take two years to get inflation back to under the Banks 2% inflation target. Having previously predicted a 2-year long recession in the UK, the BoE is now reporting the biggest of up-grades to UK growth due to the British economy’s resilience.

The BoE raised their estimate for economic activity this year and no longer think there will be a recession. More importantly, they expect year-on-year inflation to take more time to slow, to remain above 8% as of June, and to finish 2023 at 5.1%. They say the risks are skewed towards inflation continuing to be high rather than below the BoE’s 2% target.

At 10.1% in March and 8.7% in April, UK inflation remains stubbornly high. In contrast, US and Eurozone CPI rose 4.9% and 7%, respectively in April. This divergence has been driven by two main factors. First, like the rest of Europe, the UK has experienced a major energy price shock since the Russian invasion of Ukraine. Second, the UK has experienced far greater labour shortages than the rest of Europe, similar to what we have seen in the US. Many young European workers have left the UK after Brexit and older workers are leaving the labour force due to retirement or long-term sickness. This has placed upward pressure on wages and inflation.

As a result, markets have repriced their expectations of the peak in the UK base rate over the last month – they now expect a peak of 5.5% instead of the current 5%.

The problem will then be, whether, the BoE will overtighten more than is needed to rein in inflation and put the economy, which has confounded critics, under unnecessary pressure. This could be the next error from the BoE.

Critics of the BoE are asking how the BoE, can get its forecasting so very wrong. We have moved from a forecast of a 2-year recession to no recession at all. In the wake of stronger than expected survey and PMI data, the drop in energy prices and new government spending, UK GDP growth is expected to remain flat but not fall and then grow for the next two years up until 2026. This is a remarkable change of position from the BoE.

We expect to see UK inflation start to ease as the base effects turn more favourable and the impact of higher rates is felt by the real economy. In its latest forecasts, the Bank of England now expects inflation to fall to around 8% for Q2 and 5% by Q4. They expect to meet their 2% target by the end of 2024.

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