This week the Bank of England (BoE) raised interest rates to the highest level since 2008 and warned that the UK is heading into a recession. The BoE has received quite a bit of criticism for raising interest rates when their own forecast suggests the economy is heading into a recession and we won’t see growth again until 2025. Whilst the BoE should be rightly criticised for its recent management, I do have some sympathy with their current stance.
The BoE, unlike the Federal Reserve (Fed) in the US, has one mandate – to keep inflation between 1-3%. The Fed has a dual mandate – inflation between 1-3% and full employment. That is a big difference as it gives the Fed more flexibility. At present, the BoE’s mandate means that they must raise interest rates as inflation is way above target; it doesn’t matter what the underlying economy or employment market is doing. If inflation keeps rising and stays at the levels that the BoE is predicting, then they will have to keep raising interest rates, even in the face of rising unemployment and an economic recession.
There are a few reasons why I don’t have much time for the BoE 1) they overestimate their ability to predict the future 2) they overestimate their ability to effectively manage inflation (and the economy) through interest rates 3) their actions and communications don’t align 4) there is no accountability 5) the lack of diversity in executive roles leads to a cosy club of group think and poor outcomes (all executive members of the MPC are white, male and 50yrs old +).
The BoE released their Monetary Report this week, which highlights some of these issues. It states ‘Monetary policy will ensure that…. CPI inflation will return to the 2% target sustainably in the medium term’, suggesting that monetary policy alone will manage inflation, which as we’re seeing at present isn’t true. The Report also showed two BoE projections on inflation, one based on constant interest rates of 1.75% and one based on interest rates rising as expected.
If they think inflation will fall back to 2% by 2024, irrespective of whether they raise interest rates or not, then the question of why they are raising interest rates now is a good one. My view is that they don’t believe their own projections (actions and communications don’t align) and that they believe that they are important and should be doing something, even if it is counterproductive. The response from Governor Bailey to a statement from Attorney General Suella Braverman sums up my dislike for the BoE. Braverman said that interest rates “should have been raised a long time ago”, Bailey said in response “if you go back two years… I don’t remember there were many people saying that”. Why does it matter if there were millions or no-one saying that – that is irrelevant. Also, what about last year? It highlights the lack of accountability.
So does the bleak economic outlook suggested by the BoE mean we are heading to cash and selling economically-sensitive assets? No, it doesn’t. It is important to understand what sort of recession it might be and what risk is priced into assets. We agree with the BoE that a 2008-style recession and 50%+ fall in asset prices is unlikely for several reasons. A big factor is the pandemic; companies that were on the brink went bust two years ago, so there isn’t a big overhang of frail businesses. Consumers and bank balance sheets are in the good shape, again partly due to the pandemic. The biggest factor though is the strength of the employment market. Despite a rise in population in the last two years, the number of available workers has fallen in the UK and the Monetary Report has a section labelled ‘Why is the labour market so tight’. The depth of a recession is usually determined by the unemployment rate – if consumers have jobs, they might cut back spending but they will keep spending, however if consumers don’t have jobs they stop spending.
We believe that there are only a couple of areas in the market that aren’t pricing in a recession, being energy and government bonds. Most other areas are pricing in some degree of a recession. Clearly, investors might underestimate the depth of a recession and asset prices could fall further. However, what is priced in for after the recession? When things recover, which they will, the upside of bull markets is usually huge in comparison to the downside of bear markets. Whilst market falls are emotionally and financially unpleasant, we believe that it is imperative that portfolios are positioned in the right way to capture the upside.
The BoE will probably keep raising interest rates, however one thing that we’re pretty sure about is that inflation will be higher than interest rates for a long-time to come, which will make cash savers worse off. Whilst it feels uncomfortable at present because markets have fallen this year and the economic outlook is gloomy, the one benefit is that investors have priced in a lot of the bad news and if you have a longer-term time horizon, we believe it is a good time to put money to work whilst expectations are low.
Thanks for reading and