Bank of England hikes inflation forecast to 2.7pc, retreats from rate cut

In publishing its quarterly Inflation Report on Thursday, with recent data suggesting the near-term outlook is stronger than was expected three months ago, the central bank forecast a major overshoot of its 2.0% inflation target but said "there are limits to the extent to which above-target inflation can be tolerated".

Having in the prior inflation report hinted a further interest rate cut, Governor Mark Carney reminded that the MPC could respond by changing policy "in either direction" as events unfold in coming months and had "many tools" including cutting or raising rates and increasing the monetary stimulus, to ensure a return to the 2% inflation target is sustained.

On top of forecasting the consumer price index (CPI) will likely grow 1.3% in the current year, up from the previous 1.2% calculation, the bank said it expected inflation of 2.7% for 2017 and 2018, up from the prior 2.0% and 2.4% estimates.

This would be the biggest overshoot of inflation since the BoE was given the power to set interest rates in 1997.

As inflation surges, gross domestic product is predicted to grow 2.2% this year, an increase from the 2.0% forecast in August’s inflation report.

For 2017 GDP was forecast to grow 1.4%, revised much higher from 08%, while the estimate for 2018 was nudged up to 2.2% from 2.0%, though the bank stressed that the biggest determinant on the UK's outlook was the Brexit deal arranged with the European Union.

Output growth is expected to weaken more than previously anticipated, reflecting the impact of lower real income growth on household spending, with Carney seeing "very modest" real income growth due to a combination of weaker overall activity and higher inflation.

The inflation overshoot is forecast to be driven by the collapse in the sterling exchange rate, which the report mainly puts down to "a perceived shock to future supply" alongside a modest shortfall in activity.

As it stood pat on rates once more, the MPC added: "Given the projected rise in unemployment, together with the risks around activity and inflation, and the potential for further volatility in asset prices, the MPC judges it appropriate to accommodate a period of above-target inflation. That notwithstanding, the MPC is monitoring closely the evolution of inflation expectations."

Economists' analysis

Although the rise in the inflation forecast delivered the biggest overshoot relative to the 2% target since the Bank's independence, Martin Beck, senior economic advisor to the EY ITEM Club, said the MPC still looks "a tad optimistic".

"The minutes of November‘s meeting noted that there are ‘limits’ to the extent to which above target inflation can be tolerated, although no details were provided of what those limits might be. Short of a crash in the economy, this would appear to rule out further monetary easing,” he said.

Howard Archer of IHS Markit detected a significant change in the Bank’s policy stance compared not only to August’s inflation report but also to the minutes of the September meeting, with the MPC shifting to a neutral stance regarding future monetary policy from an easing bias in September.

"We now believe that it is more likely than not [that] interest rates will stay at 0.25% for a prolonged period," he said, possibly to 2020, and forecast GDP growth to slow to 1.1% in 2017 and that CPI will move above 3% in late-2017 and peak around 3.5% around spring 2018.

James Warren, a research fellow at the National Institute of Economic and Social Research, said the unchanged stance of the MPC’s communication clearly suggested they are willing to look-through this period of inflation.

“The MPC’s decision to hold the stance of policy unchanged is, on balance, the right one, especially considering the reiteration that policy stands ready to respond, in either direction, to changes to the economic outlook. The period of heightened near term inflation will likely erode the purchasing power of many households over the next year or so, leaving them less well off in real terms."

Laith Khalaf, senior analyst at Hargreaves Lansdown, said investors should not count too many chickens before they’ve hatched, as what it written on the Bank of England’s chalk board clearly does not always play out in the economy, where many variables are likely to impinge in coming months, let along the next few years.

"No doubt the sand will have shifted once again by the next time the bank issues an inflation report in February, not least because in the intervening period we will have the Chancellor’s autumn statement, a new US President, and potentially an increase in US interest rates to boot."

For savers and investors the bigger picture "remains largely the same", Khalaf said, but with low interest rate and rising inflation driving down the buying power of cash in the bank, companies are faced with a tough combination of a low growth world and rising investor appetite for dividends.