September BoE MPC Preview: Stuttering towards stagflation?

By Jeremy Hawkins, Senior European Economist
September 21, 2021

Expectations going into Thursday’s BoE MPC announcement are quite muted. Ahead of the August discussions there was significant speculation that the combination of a strong economic recovery and accelerating inflation would force the premature termination of the QE programme. However, as it turned out, no such decision was made and the only really new information provided at that meeting concerned the more longer-term exit strategy.

Since then, not only has the economy shown clear signs of slowing but in the main, the data have also been on the weak side of market expectations – Econoday’s economic consensus divergence index (ECDI) has spent most of the time in negative surprise territory. In fact, but for some positive shocks from the CPI and PPI reports, the ECDI would have been weaker still. Consequently, recent economic activity has not called for a less accommodative stance. Also boosting the likelihood of no change are two new faces on the MPC this month. Catherine Mann, former Chief Economist at the OECD and Citibank, has replaced dove Gertjan Vlieghe while Huw Pill, previously Chief European Economist at Goldman Sachs, now occupies the seat left by arch hawk and the BoE’s previous Chief Economist, Andy Haldane. The additions will return the MPC to its full complement of 9 members.

Following one-off heavy sales in the first week of September, the current buying rate of around £3.4 billion a month puts QE asset purchases on course to hit their overall £895 billion ceiling in late December. This would be in line with the BoE’s previously announced timetable and even an unexpected tapering this week would have no implications for policy unless accompanied by a change in the target stock, which seems very unlikely. Recall that Michael Saunders was the only MPC member favouring an immediate end to QE at the August meeting. In the same vein, Bank Rate is all but guaranteed to stay at its record 0.10 percent low – and probably with another unanimous vote too.

Until July, economic growth in recent months had been led by services which disproportionately benefitted from the boost to demand afforded by looser Covid restrictions. However, the sector ground to a halt at the start of the quarter and even its earlier buoyancy had helped to mask an underperforming manufacturing sector where supply bottlenecks and shortages of skilled labour continue to have a major negative impact. Hence, over the last four months, services expanded some 5.2 percent while manufacturing output rose only 0.5 percent. Indeed, monthly GDP growth has slowed from a peak rate of 2.4 percent in March to only 0.1 percent in July, and even that was essentially just attributable to a bounce in production in the volatile mining and quarrying subsector.

The BoE still expects the disruptions to supply chains to be short-lived but the PMI survey’s composite output index has fallen in each of the last three months and in August saw its lowest level since February. Similarly, the CBI’s September industrial trends survey found another, albeit limited, downgrade to companies’ expected output. Accordingly, the signs are the peak rates of growth in the current recovery cycle are now past. Supply issues are clearly a key factor in this but a fourth successive drop in retail sales volumes in August may also warn that consumer spending behaviour is becoming more conservative as rising prices eat into real disposable incomes. Indeed, the retail sector will almost certainly subtract from third quarter GDP growth. Meantime, the labour market continues to improve at a healthy clip but the ILO jobless rate is still 0.8 percentage points above its pre-crisis level. Most MPC members will want to see that gap narrow before changing policy and job prospects will not be improved by the impending termination of the Coronavirus Job Retention Scheme at the end of this month.

All that said, the key question still facing the policymakers is whether rising inflation is only transitory or a more structural problem. The August Monetary Policy Report made plain that at that time the official line was the former and, after hitting an expected 4 percent later this year, CPI inflation was forecast to return to its 2 percent medium-term target before the end of the projection period. This still seems to be the majority view. Nonetheless, with last year’s Eat Out to Help Out scheme and cut in VAT making for substantial negative base effects, the headline rate jumped by a record 1.2 percentage points to 3.2 percent in August, a 9-year high. At the same time, the core rate climbed from 1.8 percent to 3.1 percent, also its largest-ever rise and its strongest reading since November 2011. The BoE will stress the temporary nature of these distortions but, with PPI inflation currently 5.9 percent and yearly wage growth (albeit biased up by compositional effects) more than 6 percentage points above the CPI target, it must also acknowledge the risk that already rising household inflation expectations could be given a potentially dangerous boost.

In fact, having largely ignored it in recent months UK bond markets now seem to have woken up to the threat of a sizeable inflation overshoot. Between May and the end of August, gilts were quite closely correlated with Covid developments with yields falling as rising new hospital cases tempered expectations about the economic recovery. However, that link seems to have been at least partially broken this month and yields have risen quite sharply as investors weigh up the risks that above target inflation might not prove as transitory as the BoE apparently expects.

For several months inflation has been an issue for policy and, with winter approaching and gas prices soaring, the likelihood is that this will remain the case for some time. However, should inflation dampen demand further, there would be a real risk of stagflation and that would pose a much bigger problem. No growth and a sustained inflation overshoot would be close to the worst-case scenario for the BoE and significantly complicate the task of determining the appropriate monetary stance. Against this background, a shift in policy on Thursday seems unlikely even if the majority in favour of stability is a little less clear than in August.