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Here’s an extract from a recent conversation between Adam Posen — a former Bank of England Monetary Policy Committee member (he had an easy time!) and current president of the Peterson Institute for International Economics — and Bloomberg’s Odd Lots podcast team of Joe Weisenthal and Tracy Alloway (the latter formerly of these parts):
JW: I’m going to ask a random question, maybe you won’t even want to answer. I’m going to try to think about how to ask this politely. From an American perspective, when we look at what’s going on in the UK, it always just seems like one mess after another and they had to go through all these different leaders and all these weird scandals about who is at a random party or whatever, et cetera, that I don’t understand. What should Americans know about how the UK works that we don’t? Having served on the monetary policy committee, I read these headlines in The Telegraph, I don’t get it. What do I as an American, what
should I know about how England works?AP: I don’t think an American, or even an American investor or well-informed person, needs to know that much about the UK.
JW: Ok, well, that’s a good answer.
TA: That’s cutting.
Which is, uh…
Luckily, there is one group of people who can always be relied upon to find the UK interesting: UK economists.
Fellow former external Michael Saunders, now of Oxford Economics, has tackled the topic of rate-cutting in a note today, theorising that the UK’s rate-cutting cycle could be quicker than expected.
He writes:
— If recent trends in pay and prices were the only factor affecting monetary policy, then over the next 18-24 months the Monetary Policy Committee would probably aim to cut interest rates gradually to a neutral level. The MPC will probably judge this is currently around 3.25%-3.5%, with a margin of error on either side.
— However, fiscal tightening and the reduced impact of the cashflow channel argue for a fairly rapid return to a neutral monetary stance, to prevent inflation falling below target over time.
Saunders observes that four key things are different versus previous rate cutting cycles…
1) Underlying inflation remains elevated.
2) Fiscal policy is set to tighten, rather than offer support.
3) Monetary policy is having smaller, slower economic impacts (in large part, as we have written elsewhere, because of mortgages)
4) There’s much more uncertainty about neutral rates
…and argues (our emphasis):
While the trends in pay and core inflation argue for a gradual easing cycle, the prospect of significant fiscal tightening and longer monetary policy lags go the other way, and support the case for a relatively large and front-loaded easing cycle. Unless interest rates fall substantially, the household cashflow channel will continue to drag on growth in the next year or two as fixed mortgages reset upwards. With fiscal policy likely to be tightening markedly, overall economic growth may slip below potential in coming years unless private spending strengthens markedly. This seems unlikely if monetary policy remains restrictive. In turn, sub-trend economic growth would imply rising slack and point to below-target inflation further ahead.
Given monetary policy lags and fiscal tightening, in our view it’s unlikely the MPC will wait until pay growth and services inflation are at target-consistent rates before cutting interest rates significantly further. Provided pay and services inflation are slowing roughly as expected, the MPC will put more weight on their forecasts that both will return to target-consistent rates in the next year or two.
Those forecasts, incidentally, have been unpacked in a JPMorgan note today. Examining the BoE’s “leap of faith” into cutting rates, JPM’s Allan Monks and Morten Lund have constructed backward- and forward-looking measures of inflation based on MPC chatter around which components are observed. Here’s the comparison:
They write:
The backward looking indictor is running around a percentage point higher at the moment than might have been expected based on the past relationship. There is the risk, therefore, that something more permanent has changed in the inflation process that means core inflation will settle a little above 3%. This is currently a concern for the BoE’s hawks, and was highlighted by the Bank in a recent upside scenario for inflation. It may, however, simply be the case that the lags are just a little longer this time, perhaps reflecting the unique features of the pandemic. This would warrant patience on disinflation and present an argument for earlier or faster easing. This seems to be closer to the argument of the doves.
Which brings us back to Saunders: he argues that while a September cut looks highly unlikely based on MPC language, “a variety of easing paths” could follow, some perhaps quite quick.
Saunders also offers MPC members a patriotic pep talk regarding the relationship between the BoE and its peers:
At the margin, the likelihood that other major central banks will also be cutting rates as the inflation risks of 2022-2023 recede will encourage the MPC to do likewise. There often is a sort of intellectual spillover, whereby central banks tend to be more confident in their diagnosis and their response if other central banks act in a similar fashion. But, unless the actions of other central banks or other factors cause sterling or other asset prices to move sharply, the MPC’s focus will remain mainly on domestic factors rather than external constraints. The MPC does not need to shadow other central banks.
He concludes:
Market pricing currently implies that Bank Rate will fall to about 3.75% at end-2025 and stay around 3.5% thereafter. That end-2025 level looks reasonable, and is similar to the OE forecast.
Still, assuming credible fiscal tightening is in place while pay and core inflation are slowing, it’s worth considering a scenario in which interest rates return to neutral (i.e., 3.25%-3.5% or so) fairly quickly – within the next four or five quarters.
Further reading:
— Some moderately cohesive thoughts on the UK’s economy
