The Bank of England said on Thursday there were limits to its tolerance of higher prices as it forecast the biggest sustained overshoot of inflation since it gained independence to set interest rates in 1997.
The pound’s fall will raise import prices sharply, the bank’s Monetary Policy Committee said, as it forecast inflation would exceed its 2 per cent target by spring next year, peak at 2.8 per cent in early 2018 and stay above 2.5 per cent well into 2019 before returning to target only in 2020.
With inflation on the rise, the committee has dropped its guidance that the next move in interest rates was likely to be down and said they could move in either direction, depending on the performance of the economy.
“There are limits to the extent to which above-target inflation can be tolerated,” the minutes of the November MPC meeting said.
The sharp rise in prices alongside a growing expectation of a hard Brexit has left the central bank with a slightly more gloomy outlook than it had in August, despite robust economic growth since the EU referendum in June.
There are limits to the extent to which above-target inflation can be tolerated
Its downbeat forecasts are bound to anger Conservative Brexit supporters who complain the BoE has repeatedly proved to be too pessimistic and is talking down the UK economy to justify its warnings about leaving the EU.
The MPC admits that the post referendum economy has been “notably stronger” than it expected, but urged caution, suggesting the good times would not last.
The three big changes to the forecast reflect better than expected economic data since August; the further 6 per cent drop in the value of sterling; and a heightened expectation that the country is heading for a hard version of Brexit.
In the MPC’s view, the hit to household incomes from higher prices and the damage from perceptions of a harder Brexit will more than offset the better data so far and the boost to exporters from a weaker pound.
Officials said the BoE had raised its forecast of the cumulative Brexit effect on the economy by mid-2019 to “slightly above” the 2.5 per cent estimated in August.
With inflation projected to rise far above the BoE’s 2 per cent target and stay above target for at least three years, the MPC is beginning to get more worried that it will not be able to stick to its current view that it will “accommodate” the price rises and might instead have to raise interest rates to contain inflation.
The bank was careful not to give precise figures for the limit to its tolerance of high inflation. It would depend on whether it was feeding into a spiral of further price rises and whether economic weakness was likely to restrain price rises, the bank said.
The MPC said its guidance that the next move in rates was likely to be a cut “had expired” and that interest rates in future “could respond in either direction to the economic outlook as they unfolded to ensure a sustainable return of inflation to the 2 per cent target”.
Recent strong economic growth has been helped by robust consumer spending, with households showing few signs of nervousness. But this is in sharp contrast, the BoE said, to growing evidence from businesses and financial markets that they are concerned about what Brexit will mean for the UK’s trading relationships and growth.
The MPC said this divergence would be “resolved over time” as “the nature of future international trading relationships . . . became clearer”. Either “investors’ assessment of the outlook for income growth [would become] more positive” or “households’ spending would slow”, they said.
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