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Inflation will hit 4%, but rates won’t rise

  • Bank of England forecasts 4% inflation but is keeping rates and QE on hold
  • Bank outlines its exit plan for QE
  • Banks are ready for negative rates- but the world has moved on
  • Cash savers beware – inflation is expected to be over 3% this time next year and still over 2% in two years’ time

 

Laith Khalaf, head of investment analysis at AJ Bell, comments:

“Andrew Bailey better get his quill and inkpot out, because it’s looking like he’s going to be writing a number of letters to the Chancellor to explain why inflation is more than 1% above the Bank of England’s target. CPI has risen from 0.7% to 2.5% this year, and the Bank of England now expects it to rise to 4% at the end of 2021. Despite that, the Bank isn’t inclined to hike interest rates, or reduce QE.

“There is some method in the Bank’s madness. The utterly disruptive nature of the pandemic means the annualised economic data points we’re getting now are distorted by policy measures like furlough, combined with the extreme distress we saw in energy markets last year. They’re not so much a measure of where we are today, as how things stood last spring and summer, as the pandemic was at its worst. The Bank also has the ammunition to deal with inflation, by raising interest rates and QE, but there’s not much room for manoeuvre in the opposite direction if it needs to stimulate the economy because of another slowdown. It’s therefore likely to err on the side of being too loose with monetary policy rather than too tight.

“Of course that means we could be watching an inflationary spiral take off right before our very eyes if the Bank’s judgements on the transitory nature of price rises are wide of the mark. Even by the Bank’s own forecasts, sustained inflationary pressures are here to stay. The Bank forecasts 4% inflation at the end of this year, 3.3% inflation in one year’s time, and 2.1% in two years’ time. This will not come as welcome news to cash savers, particularly when the central bank is not raising rates. Taken together, those three inflationary figures would mean £100 in an account paying no interest being worth around £91 after 3 years. The household sector currently holds £240 billion in accounts that pay no interest, and are unlikely to until the bank raises rates. At least negative rates look to be off the table, even though commercial bank systems are now fully prepared to accommodate them after a six month preparatory period, which is a measure of how much the world has moved on in that time.

“The Bank of England has also outlined how it intends to unwind QE when the time comes. It will rely initially on simply not reinvesting the proceeds of maturing bonds in the QE programme, but won’t do this until interest rates rise to at least 0.5%. The Bank won’t actually sell any bonds until interest rates hit at least 1%. The Bank seems relatively sanguine about its ability to unwind QE in a predictable and gradual manner, and perhaps that is because it is focused on the direct effects on the UK economy. However the tightening of monetary policy and the unwinding of QE will have a big and damaging impact on the bond market and the public finances.

“The government currently pays bank rate of 0.1% on bonds held in the QE programme, so as base rates rise and QE remains in place, the Treasury’s interest bill balloons. The OBR reckons that a 1 percentage point rise in interest rates equates to £20.8 billion more in interest for the Exchequer in 2025/26. If inflation does take off, and interest rates rise, the Chancellor will have a big job on his hands to balance the books.

“The bond market is also highly susceptible to inflation, rising interest rates, and the unwinding of QE. For the last 12 years, bond prices have soared thanks to the continued activity of a price-insensitive buyer in the form of the central bank. This long-standing asset bubble could come to a nasty end when the QE engines into reverse, which will be exacerbated by the fact that those who buy bonds tend do so because they regard them as safe assets.”

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