MNI INSIGHT: BOE Multipliers Imply Rate Expectations Overblown

Estimates of monetary policy multipliers suggest that the Bank of England might need to raise interest rates by much less than markets expect to bring inflation back to target, though the extent of eventual tightening will depend on whether the current spike in energy and food prices flattens out without driving second-round effects as BOE officials assume.

The BOE does not publish its view of the multiplier effect of monetary tightening on inflation, but the National Institute of Economic and Social Research has made similar calculations. Using the central bank’s assumption that inflation will head back towards 3% even if rates are left unchanged, NIESR estimates indicate that the tightening necessary to return to the 2% target would be around half the 150 basis points factored in by the market.

Interest rates may only have to increase by about 80 basis points from the current 1% to achieve the BOE’s aims, according to a simulation on the NIESR model run by NIESR Deputy Director Stephen Millard, formerly a senior research manager at the Bank.

“This led to a fall in inflation of roughly 1.1 percentage point two years out. So, a 150-basis point rise in interest rates would lead to a roughly 2-percentage-point fall in inflation,” said Millard.

Such a policy multiplier was higher than expected and much stronger than a ready reckoner based on the difference between the Bank’s constant and market rate forecasts, Millard said.

MULTIPLIER CALCULATIONS

The Bank prefers not to publish its multiplier estimates. Investors would leap on them as a guide to future rates moves and the Monetary Policy Committee could find itself exposed to criticism if its actions appeared inconsistent with any such calculations. Governor Andrew Bailey is also wary of guidance, highlighting its shortfalls at times of uncertainty such as the present, with the MPC even splitting over its current minimal steer that further tightening might be required. (See MNI INSIGHT: BOE Rates Guidance Underplays Tightening Bias)

In its May Monetary Policy Report, the BOE said that if rates followed market expectations then inflation would fall from a peak around 10% to 6.6% in the second quarter of next year and drop to 2.1% by the second quarter of 2024.

But leaving rates unchanged would still see inflation fall to 2.9% two years out. This implies that the BOE will only be looking to knock 0.9 percentage point off inflation via monetary tightening.

Both the Bank and NIESR “are relying on inflation to fall naturally as the rise in energy and food prices ‘drops out’ of the annual comparison,” Millard said. “Monetary policy is doing a relatively small proportion of the work.”

This assumes that higher inflation expectations do not lead to higher wage increases and higher core inflation, which Millard called “the main risk to the overall inflation forecast.”

Bank officials are aware of the danger that inflation might prove harder to combat than hoped, and the difference between the market’s rate outlook and the BOE’s current likely intended path could come down to differing calculations about prices. If higher inflation does become embedded after commodity effects subside, rate hikes could end up aligning more closely with the 150 basis points of market expectations even if policy multipliers remain relatively high.