Inflation could overshoot forecasts, says incoming deputy Bank governor

Incoming Bank of England deputy governor Sarah Breeden said that price rises are more likely to overshoot than undershoot forecasts but that she expects the Government to reach its target to halve inflation by the end of the year.

In a response to the Treasury Committee, Ms Breeden said that the Bank’s latest set of inflation forecasts are “skewed to the upside”.

It echoes the words of the Monetary Policy Committee (MPC), the interest-rate setting body which she is set to join on November 1.

Turning to risks to the UK outlook, I agree with the MPC that the risks to inflation around the August forecast are skewed to the upside

She said that so-called second-round effects, where workers ask for higher wages because the cost of living is rising, and businesses price their products higher to offset their rising costs, are stronger than had been expected.

“Turning to risks to the UK outlook, I agree with the MPC that the risks to inflation around the August forecast are skewed to the upside,” she said.

“We have learned, in particular, that second-round effects via price and wage setting are stronger than had previously been expected.”

She said that inflation was likely to reach around 5% by the end of the year, which would mean that the Government’s target to halve inflation would be met.

It came alongside a hearing to approve Ms Breeden’s appointment to the MPC. She is set to become deputy governor for financial stability, replacing Sir Jon Cunliffe.

She told MPs during the session: “I think the challenge right now is that wages are high and rising and there is a real risk that the second-round effects mean that this inflation becomes embedded.

“I would say we are not forecasting a recession … it is not our intent to cause a recession, and the MPC will be very careful as it takes its decisions.”

She also said that the UK’s economy is “weak in absolute terms”, with gross domestic product (GDP) just a little ahead of where it had been before the pandemic, despite a recent upgrade in the official statistics.

Whilst much of the impact of the rise in Bank Rate is to come, this monetary policy action has already materially pushed down on inflation

Inflation could have been around three to five percentage points higher than it is if the MPC had not hiked interest rates over the last two years, she said.

But she added that if they wanted to totally offset rising inflation, the MPC members would have had to increase rates twice has fast as they had, which could have sent shockwaves through the economy.

“UK economic activity is weak in absolute terms. GDP is only slightly above its pre-Covid level and remains a long way below its pre-Covid trend. Consumption is even weaker than GDP,” she said.

She added: “Whilst much of the impact of the rise in Bank Rate is to come, this monetary policy action has already materially pushed down on inflation.

“Indeed, a simple rule of thumb would suggest that inflation could have been around three to five percentage points higher had the MPC not increased Bank Rate.

“Had the MPC sought to offset entirely the overshoot of inflation above target over the past couple of years, they would have had to do two things.

“First, they would have had to foresee the effects of the recovery from Covid on import prices and excess demand, as well as the impact on inflation from the invasion of Ukraine, well in advance of them happening.

“Second, they would have had to increase interest rates to more than double their current level.

“This would have led to a deep (global financial crisis-sized) recession, a huge increase in unemployment and a fall in nominal wages just as the economy was recovering from Covid-19. Neither of these seem like plausible counterfactuals.”