Bank of England was too Downbeat says Capital Economics, 3.0% Bank Rate Still Likely

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The Bank of England is too pessimistic in its economic forecasts and it will have to raise interest rates far higher than it currently expects, according to an independent research consultancy.

Capital Economics say the Bank is underestimating the potential for ongoing strength of the UK labour force, while they anticipate further support to be offered by the government as it grapples for credibility in the face of a 'cost of living crisis'.

The Bank of England sent Pound Sterling wheeling lower after it released economic forecasts that showed UK GDP would likely fall by 0.25% in 2023 and rise by just 0.25% in 2024.

But economists at Capital Economics say there are three reasons why the Bank of England’s forecasts for GDP will prove to be too downbeat, which in turn has implications for the outlook of UK interest rates.

1) The Bank assumes that energy prices are constant after six months, which Capital Economics see as being unlikely.

"If the Bank were to assume that energy prices fall back to the levels implied by futures curves, then GDP growth would be about 0.3 percentage points (ppts) higher in both 2023 and 2024," says Ruth Gregory, Senior UK Economist at Capital Economics.

This assumption relies on current observations that show future energy prices are expected by the market to fall back beyond six months.

2) The Bank assumes that fiscal policy evolves in line with announced government policies.

"It is hard to see the Chancellor holding off on more help for households. A similar sized fiscal package to that unveiled in March could add up to 0.5% to the level of GDP," says Gregory.

Above: Real GDP (%q/q). Image courtesy of Capital Economics.

3) There may be a bit more scope for households to run down their excess savings.

"That, and our assumption that the limited supply of workers will keep the labour market tighter for longer explains why we think consumer spending will hold up better than the Bank expects," says Gregory.

The Bank of England expects the unemployment rate to fall in 2022 and 2023 but rise to 5.05% in 2024.

"Our central view is that the economy will not be as weak as the Bank expects," says Gregory.

Peak CPI inflation is meanwhile forecast by the Bank to come in at 10.2% in the fourth quarter, up 4.4% on their previous estimates, while the 2023 fourth quarter figure is seen at 3.6%, a revision up of 1.1%.

Despite the hefty inflation forecasts the Bank sent a clear message to markets that they were anticipating too many rate hikes over coming months, citing a market implied peak rate of 2.5% in their forecast models.

Under such conditions the economy would shrink in 2023, hence why the Bank was of the view a rapid pace of hikes was unlikely.

But Capital Economics thinks the economy will prove more resilient and the Bank is therefore underestimating the task at hand.

"Our central view is that the economy will not be as weak as the Bank expects," says Gregory.

The Bank anticipates that much of the heavy lifting in bringing inflation back lower to the 2.0% target will be done by a stalling economy.

But Capital Economics says this assumption is misplaced and the Bank will need to do more than it currently expects.

"We think that in order to offset longer-lasting domestic price pressures, the MPC will have to raise interest rates much further than it expects," says Gregory.

Capital Economics maintain a view the Bank will hike rates to 3.00% next year, suggesting the market is now at risk of massively under-appreciating what is coming down the line.