Inflation is forecast to hit 4% this year as Britain’s robust recovery from the pandemic accelerates at a blistering pace, the Bank of England has said, hinting that a modest increase in interest rates next year might be needed to keep rising prices in check.
With most of the economy open and businesses reporting strong sales, the central bank’s monetary policy committee (MPC) said the economy would grow by 8% in 2021 – up from a forecast in May of 7.25% – to regain its pre-pandemic level of activity by the end of this year, rather than spring 2022.
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Keeping the current base rate at 0.1%, the MPC forecast that the rise in inflation was likely to be temporary as the current surge in energy and imported goods began to wane, pushing down prices growth next year towards its 2% target.
However an increase in interest rates is likely sometime over the next 12 months to make sure inflation continues to fall back, though any rise will be modest to maintain the recovery.
“CPI inflation has risen markedly, to above the monetary policy committee’s target of 2%, and is projected to rise temporarily to 4% in the near term. The rise largely reflects the impact of the pandemic as the economy recovers,” the Bank said in its latest monetary policy report.
“This has led to higher energy and goods prices, which in turn reflect rising commodity prices, transportation bottlenecks, constraints on production and strong global demand for goods. As such, above-target inflation is expected to be transitory, as commodity prices stabilise, supply shortages ease and global demand rebalances,” it added.
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Some City analysts said the bank’s quarterly economic health check showed there was pressure from inside the MPC to increase the cost of borrowing earlier than previously expected and possibly as soon as spring next year.
“If there is no other major wave of Covid-19 during the winter and the economy performs in line with the Bank’s forecasts, the first rate rise is likely to come in the spring or early summer of next year,” said Ian Stewart, the chief economist at the consultancy Deloitte.
Others said there could be a delay to any tightening of monetary policy until 2023. Marchel Alexandrovich, and economist at the investment bank Jefferies, said officials wanted to maintain flexibility and “any serious discussion around the timing and the extent of future rate rises is unlikely to start until well into next year at the earliest”.
In its upbeat assessment of the recovery, unemployment will peak at its current level of 4.8%, meaning there will be no negative fallout from the ending of the furlough scheme in September, according to the MPC. Wage rises, which it said were averaging 3.5%, would also remain strong.
Michael Saunders, a former investment bank economist and one of nine members of the MPC, has argued that the bank should take a tougher line on inflation now that the recovery is in full swing. He voted to limit the BoE’s £895bn quantitative easing programme in opposition to the rest of the committee, who wanted to complete the bank’s stimulus plan through to the end of the year.
Yet while MPC members rejected an immediate policy change, they agreed to start cutting back on QE by not reinvesting maturing bonds once the base rate has risen to 0.5%, and they plan to begin reducing the stockpile back towards its pre-pandemic level once the base rate has hit 1%.
“The committee judges that, should the economy evolve broadly in line with the central projections in the August monetary policy report, some modest tightening of monetary policy over the forecast period is likely to be necessary to be consistent with meeting the inflation target sustainably in the medium term,” it said.
Hugh Gimber, global market strategist at JP Morgan Asset Management, said the UK domestic outlook was strong, but “uncertainty linked to the Delta variant and the phasing out of the furlough scheme” made policymakers wary of any premature withdrawal of support.
The Bank is due to complete its current QE programme by injecting the last £50bn into the economy by the end of the year.
The fresh forecast for growth in 2021 would make it the fastest since 1941, when Britain’s war machine was working at full capacity during the second world war and GDP expanded by 8.7%.
It predicted that UK GDP rose by 5% in April-June, higher than forecast three months ago, as the easing of lockdown restrictions boosted growth. But it also warned that recent developments in the pandemic meant growth in the third quarter of 2021 would be “somewhat weaker than expected in the May report” at 3%, pointing to the “sharp increase in the number of people being asked to self-isolate temporarily” since its last meeting in late June.
Officials at Threadneedle Street said the swift recovery would combine with shortages of raw materials and energy prices to send inflation 4% for the first time since 2011 when it reached 5% before falling back to zero, mostly driven by the see-sawing price of oil.
The MPC also said it was mindful of statements by Rishi Sunak that in the autumn, the Treasury would announce plans to cut back on government spending next year, reducing the growth potential of the economy.
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Ruth Gregory, an economist at the consultancy Capital Economics said the Bank used its economic forecasts to convey a more upbeat message about the economic outlook.
“Indeed, while the economy is still expected to regain its Q4 2019 pre-pandemic peak in Q4, the Bank now thinks that instead of peaking at 5.4% in Q3, the peak in the unemployment rate has already happened,” she said.
“By talking about the mechanics of tightening policy, that is another signal that tightening is drawing nearer,” she added.