What will the Bank of England do next?

Last week, Bank of England (BoE) Governor Andrew Bailey warned of a deep and prolonged recession (about 2.2% peak to trough), with little or no growth in 2024-2025. Given how seldom central banks predict recessions in advance, this gives us a strong indication of his conviction.

That said, there is still some hope, as the BoE’s projections make no allowance for a fiscal policy response, nor for any fiscal stimulus that arrives earlier due to the next prime minister.

Amid the Conservative party leadership election, various claims have been made about the possible outcomes of fiscal policy decisions and the role of the BoE. Before examining the credibility of these claims, we need to be humble. Very few actions in economics have clear, irrefutable outcomes, and as Elon Musk said last week “making macroeconomic prognostications is a recipe for disaster”.

Fiscal stimulus = higher interest rates?

First, let’s tackle whether large fiscal stimulus would lead to higher interest rates.

It probably depends on the timing. Unemployment is very low, and the BoE will worry that significant extra demand now would add to wage inflation, and the bank would likely react with rate hikes.

However, if fiscal stimulus comes later, it could just partially offset what they see as an inevitable recession.  

Is the BoE to blame for high inflation?

Second, it’s been suggested that the BoE is responsible for the very high current level of inflation, and so should have its mandate adjusted.

That feels like a rather harsh interpretation given how much of the current shock has been from supply-side issues such as energy prices and COVID-19-related supply disruptions.

That said, sterling weakness has also played a role. Acting earlier might have supported the currency, as it did for emerging market countries that got ahead of the curve.

When the UK and Eurozone hike rates, does it make sense?

We don’t think anyone knows, despite the confidence with which central banks speak and act. The BoE’s warning of a prolonged recession came alongside its decision to raise interest rates by the largest amount in 27 years, evidence of its continued commitment to fight inflation.

The framework its applying, however, isn’t as robust or clear-cut asits action might imply. There was even a Federal Reserve paper in 2021 that outlined it isn’t well supported empirically or theoretically, and it made a case that following the framework uncritically could lead to serious policy errors.

It might be that the cost-of-living crisis is enough to slow the economy and reduce inflationary pressures, in which case the BoE is just exacerbating the almost inevitable recession.

What does all this mean for investors?

So how do we deal with this uncertainty? Given the lack of evidence, we see central banks’ framework as conjecture at best. That means we’re avoiding being dogmatic about the effects their policies have.

What we have more conviction in is central banks’ commitment to their framework, at least for now. So, in the face of likely higher fiscal stimulus from the next UK prime minister, we believe the risks are that the BoE feels compelled to do more, and that’s a big part of why we’re tactically short gilts versus bunds.