The risks of a central bank induced recession and policy error are high and rising, says M&G’s Ben Lord

by | Mar 16, 2022

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Ben Lord, Fund Manager at M&G Investments, comments ahead of the Bank of England interest rate decision tomorrow.

“Following the BoE’s steer for a hike that never materialised in October or November, and its subsequent first hike in the BoE’s history in the month of December, it is important to recognise that it is much harder to predict the decisions of this Bank of England than it has been in a long time. So be humble.

“The Bank of England is expected to hike this week, by 25bps, taking the base rate to 0.75%.

“The reasons for a hike: inflation, inflation, inflation. And inflation expectations. 10yr RPI breakevens have been above 4% since October, so the bond market was worried about building long term inflation pressures long before the conflict began. Now we have this additional risk to commodities, energy and food, which all add additional pressures to supply chains. And that is without mentioning the demand side of things, which so far at least remains robust. Economic data suggest the UK economy is currently in a strong enough shape to tolerate further interest rate hikes, with labour market data continuing to tell a story of strong demand for workers and limited supply of them. Wages also remain solid, albeit down from the lofty levels of last summer. Central banks will be worried primarily about inaction aiding further second order upward pressure on inflation in coming years.

 

“The reasons against a hike: inflation was already high before the Ukraine horror began, driven by supply chain issues and high demand resulting from fiscal and monetary policy during the pandemic. The Philipps Curve has woken after a long period of dormancy, and tight labour markets are seeing solid wage growth, whilst rental prices are predictably higher, following property prices with a lag. And now we have this conflict, so food, energy, and the movement of everyone and everything are seeing rapidly rising prices. These categories of spending represent a large majority of spending items for a large proportion of the population, and the conflict suggests that the chances of wages returning to positive territory in real terms is now more remote and further away. Thus, the outlook for consumption has taken a darker turn. Interest rate hikes will further hurt the consumer, although it is worth noting the significant changes in mortgages in the UK over the last 10 and 20 years, which should alleviate this impact, relative to previous hiking cycles anyway.

“What should they do? Central banks are a long way behind the inflation curve. Inflation is too high, and recent tragic developments suggest risks are further to the upside for inflation in coming months. The BoE needs to hike rates for a number of reasons. Firstly to send a signal to bond markets that it is getting serious about bringing inflation back down to more sensible levels. Secondly central banks need to tighten financial conditions to calm down economic strength and so too fundamental inflation in the future. They need to try to tread the line between killing growth and bringing recession on the one hand, and letting inflation get out of control on the other. This is a dilemma, and so it seems most likely that a preference will have to be made between the two. The risks of a central bank induced recession and policy error are high and rising. But given how high inflation is, how elevated expectations are, and how behind the curve central banks are, we all need to prepare ourselves for a series of hikes in the coming months and perhaps years, depending on what happens to aggregate demand. And we also need to prepare for the risks that such monetary policy action could have on consumption, the economy and portfolios.”

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