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UK economy walking an “unpleasant tight rope”

UK economy walking an “unpleasant tight rope”
Photo by Marcelo Moreira via Pexels

The latest update from the Bank of England has indicated that the UK economy is likely to be in recession until 2024.

This leaves the policy makers walking a “very unpleasant tightrope” as they set monetary policy, according to Iain Barnes, head of portfolio management at Netwealth.

He was commenting in the context of the bank raising rates by 0.75 percentage points, to 3 per cent, a level not seen since 2008.

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Particularly worrying for policy makers is the reaction of sterling, which fell sharply against the dollar today.

Typically, when rates rise, it should boost the value of the currency, as higher rates incentivise investors to hold the asset.

But Barnes said investors had expected a rate rise on today’s scale, but has been spooked by governor Andrew Bailey’s comment after the rates announcement, where he said the pace of future rate rises will be slower “than has been priced in by markets.

"The reason Bailey gave for this is that he does not feel the economy can handle a higher pace of rate rises.

But if the rates don’t rise, that causes inflation to persist, and inflation makes people poorer, and no central banker wants to do that. It is a very difficult tightrope.”

Luke Bartholomew, senior economist at Abrdn, elaborated on the nature of the “tightrope.”

He says: “Some aspects of the Bank’s forecasts are rather less informative than usual given the uncertainty over fiscal policy in general and energy policy in particular.

"However, the overall message is clear. The Bank thinks that if it were to deliver a rate hiking cycle in line with current expectations of investors, this would lead to a prolonged and deep downturn.

"So the Bank’s hope is that by hiking more today and in the near future, it will ultimately need to deliver less hikes."

According to Barnes, this is a "tricky message to communicate", and it remains to be seen how open markets are to it given the recent period of volatility and the Bank’s track-record of underestimating how much tightening it ultimately delivers.

Barnes said he believes bond markets have dealt with recent macroeconomic announcements in a “calmer” way than equity markets, as he feels the former had priced in a greater quantity of bad news.

Two scenarios

Edward Park, chief investment officer at Brooks Macdonald, said: “The Bank of England laid out two scenarios, one where rates rose to the 5.25 per cent expected by the market. In this case, the Bank forecasts a recession which would past two years.

"In the alternative scenario, where interest rates stayed at the new rate of 3 per cent, the Bank forecasts only 5 quarters of contraction.

"In both cases, inflation undershoots its target towards the end of the forecast period, this could mean the long awaited ‘pivot’ is coming into sight.”