- The Bank of England’s latest monetary policy report surprised with its gloomy economic projections
- But in a time of high uncertainty, individual forecasts should not be given too much weight
August’s monetary policy report saw the Bank of England (BoE) announce a 0.5 percentage point increase in interest rates. That much was expected. But what caused shockwaves was the BoE’s predictions for the UK economy, which were significantly more pessimistic than May’s forecasts. Under the latest projections, the economy will soon enter recession – and stay there for over a year.
But though there is widespread consensus that the economic outlook has darkened, there is a chance things might not be quite as bad as the BoE’s forecasts suggest.
According to the August projections, the UK economy will contract in the fourth quarter and continue to shrink over the course of 2023. This sharp drop in economic activity will be driven by “the significant adverse impact of the sharp rises in global energy and tradable goods prices on UK household real incomes”. As the chart shows, the Bank expects the recession to be relatively deep, with a peak-to-trough contraction of 2.25 per cent. Soberingly, it is also expected to last for five successive quarters – as long as the 2008 recession.
But not all forecasts are so bearish. Economists at Panmure Gordon predict a shorter, two-quarter contraction, and Capital Economics also foresees a shallower recession. Samuel Tombs, chief UK economist at Pantheon Macro, even argues that recession could be avoided. So why is the BoE so pessimistic?
Firstly, because it is bound by a number of forecasting conventions – and this is more interesting than it sounds. In 2019, the BoE set out a method for modelling energy prices which assumes that they first follow their futures curves, then remain constant after six months. This statistical quirk was designed to make forecasting simpler, but now has significant impacts: under the BoE’s projections, energy prices are assumed to stay at high levels over the forecast period. When the BoE adapts its model to allow energy prices to follow their (downward sloping) futures curve instead, the picture looks a little brighter: GDP contracts by 1.5 per cent instead of 2.1 per cent by the third quarter of next year.
What’s more, the BoE’s models only take current (or pre-announced) government policies into account. In normal times, this makes sense – there is usually a similar chance of fiscal policy becoming tighter or looser as the forecast period evolves. But with a new prime minister taking office in September, some level of fiscal stimulus looks almost certain. Further government action on energy prices could easily double the £37bn in help announced earlier this year. Under these conditions, the recession would be significantly milder: Panmure Gordon projects a two-quarter contraction, before a return to growth in Q2 2023. Pantheon Macro’s Tombs also argues that “with extra government support likely to be announced shortly after the new PM takes office, and households still holding considerable savings, a recession is not inevitable”.
It is also worth cautioning that today’s forecasts are being produced in a climate of high uncertainty – especially where energy prices are concerned. The BoE is at pains to stress the “exceptional level of uncertainty” surrounding its forecasts, and notes that it is putting “more weight than it would normally” on its alternative energy price projections. In this environment, we should not be surprised that different forecasts are yielding such varied results.
The FTSE 100 was relatively flat after the BoE announcement, and even the currency market reaction was relatively muted – perhaps markets took the announcement with a pinch of salt, too. But the calm could prove short-lived. Capital Economics’ chief UK economist, Paul Dales, argues that the equity market hasn't fully priced in the economic weakness ahead, and anticipates that we may yet see a downward adjustment.
There is an old joke that economists have predicted 20 of the past two recessions – unfortunately, it looks as though this time they might be right. But given the uncertainty surrounding energy prices and fiscal policy, the outlook may prove brighter than BoE forecasts suggest.
