MNI POLICY: BOE Looks Set To Edge Up Neutral Rate Estimate
MNI (LONDON) - The Bank of England looks set to revise slightly higher its estimate of the neutral rate of interest in its February Monetary Policy Report, implying that current policy is not as restrictive as previous estimates suggested and that Bank Rate may have a little less far to fall to hit it.
The last time an MPR contained formal estimates of the neutral rate was in August 2018, under former Governor Mark Carney, during a period when academic research had pointed to its decline due to factors including debt, demographics and weak productivity growth. Back then the Bank published several estimates showing neutral had fallen to around 0%–1% in real terms, with a modal estimate of around 0.25%, or 2.25% nominal. A new estimate should push this at least a little higher.
Monetary Policy Committee member Alan Taylor, in his inaugural speech on Jan 15, noted recent private sector estimates of the real neutral rate range stretch from 0.5% to 1.0%, suggesting a level "just a touch higher" than previous modelling.
"Adding the inflation target of 2%, I would see policy rates levelling off at a terminal rate of 2.75%," Taylor said. This compares to the current policy rate of 4.75%, with markets pricing in around 77 basis points of cuts by year-end, including 25bp this week.
Taylor said this estimate would put the BOE's neutral real rate between that implied by the Fed's dot plot, of around 1%, and the European Central Bank’s of around zero, a reasonable assumption.
His colleague Megan Greene has consistently said, from before joining the MPC through into her speeches, that she believes that the neutral interest rate may have risen, and has noted how many private economists have revised their estimates higher since 2022.
CAVEATS
If the MPC does publish a fuller analysis in the MPR it is likely to come with caveats. Bank estimates have repeatedly warned of the uncertainty around calculating neutral, which the MPC divides into the shorter-run rate, known as lower case, r* and the longer-run, upper case, R*, estimates for both of which are likely to be published on Thursday.
Almost inevitably, MPC members will also disagree on some of the assumptions about estimating neutral.
The third of the committee’s three current scenarios for the economy, backed by MPC member Catherine Mann, assumes that structural changes have pushed r* higher. This would suggest a higher rate than that implied by the first two scenarios, at least in the short-run.
DISENTANGLING SUPPLY AND DEMAND
Another question that the MPR will answer is whether the committee has moved beyond the three scenarios, though February may be too early for a rejig. Taylor has already sketched out a fourth, in which the committee needs to take the policy rate into stimulative territory to offset growing evidence of economic weakness.
At the press conference Governor Andrew Bailey is also likely to face questions about how the MPC thinks higher effective interest rates, stemming from rising sovereign debt yield curves, affect both the real economy and policy. These questions could be addressed in the MPR, but the MPC has so far ducked clearly setting out its analysis of how the impact of uncertainty generated by the U.S.'s very-fast-changing trade policy. (See MNI INTERVIEW: Gilt Hit Weighs On Inflation - Ex-BOE Saunders)
A supply stocktake should also help disentangle how much of recent inflation and disinflation has been due to supply or demand.