MNI INTERVIEW: BOE Right To Be Cautious Over Cuts - NIESR

The Bank of England is right to adopt a cautious approach to easing monetary policy given the risk of having to change course and tighten should inflation flare again, National Institute of Economic and Social Research senior economist Ben Caswell told MNI.

Successive inflationary shocks from fiscal stimulus during Covid and then from pent-up demand during economic re-opening, followed by Russia's invasion of Ukraine left the Bank of England playing catch up as it tightened, but easing to quickly or too early as these shocks wear off would expose it to a potential policy reversal, in Caswell's view.

“I think there is caution this time around, given the past two, three years’ experience of having these layered shocks, one on top of another. The worst-case scenario is that the Bank of England starts cutting, and then something materialises and they have to rewind and start hiking rates again, because that creates a lot more instability and uncertainty and doesn’t give confidence to markets going forward," he said, "For example, if the Bank goes in one direction and then has to reverse it a few months later. So I think they want to obviously avoid that at all costs."

CITED BY BAILEY

BOE Governor Andrew Bailey cited NIESR's support for gradualism in evidence to lawmakers on the Treasury Select Committee on Feb 20, using the institute's lines that there should be no rush to cut interest rates and that “slow and steady will win the day.”

NIESR's latest forecasts have inflation falling rapidly to below the 2% target, hitting 1.2% in the second quarter before moving back up to around target by year-end. But this pattern does not justify a more aggressive approach to easing, Caswell said.

“They’re leaving that space there in case there are any upward pressures on inflation that materialise before that [first] rate cut takes place," he said. "Without any rate cuts, it may just come down to 2% naturally as base effects drop out of the headline rate of inflation.”

NIESR and others criticised the Bank for being too slow to respond to inflationary risks during the tightening cycle, but Caswell noted that the risks from prices surging as it eases are far lower than those prompted by the extraordinary events of Covid and the invasion of Ukraine. The Bank should also have the confidence to be clearer in its guidance about future rates moves despite the need to remain data-dependent, he said, noting that both the European Central Bank and the Federal Reserve have provided more definite signals as to when rate cuts are likely. (See MNI INTERVIEW: Forward Guidance Key Tool However It is Called)

LABOUR MARKET TIGHTNESS

One clear upside risk for the Bank stems from the tight labour market, partly due to increased long-term sickness, he noted. (See MNI INTERVIEW: Better ONS Data Suggest Easing UK Labour Market)

“We still do have a labour market which is a bit dysfunctional ... we still have an elevated level of inactivity, and we still have also fewer hours work per person. So the labour market hasn’t really returned to what it was before the pandemic either," Caswell said, adding that the planned rise in the National Living Wage in April will add to upside pay pressures.

“It’s almost a 10% increase. And this also puts compression on differentials at the bottom of the wage distribution. So if you’re somebody who's on just above minimum wage, you’re going to find that you’re at the bottom and that’s going to put up the pressure and subsequently people near the bottom of the distribution are going to try and bargain for more,” he said.

Markets have factored in the BOE's commitment to gradualism, with around 60 basis points of cuts currently priced in for 2024 compared to pricing for 15O at the end of 2023 when markets anticipated a more dovish stance.