The Bank of England plans to lower economic forecasts. Is the nightmare of "stagflation" returning?

According to Zhitong Finance APP, the Bank of England may deliver a heavy blow to Chancellor of the Exchequer Rachel Reeves this week, as it plans to lower economic growth forecasts and warns that her October budget will drive up inflation. Previously, the Chancellor announced a package of measures to stimulate the economy.

Economists indicate that although the Bank of England is expected to cut interest rates for the third time since last August on Thursday, its latest forecasts may exacerbate market concerns about the UK falling into stagflation.

Respondents to a survey unanimously expect the Bank of England to cut rates by 25 basis points to 4.5%, the lowest level since June 2023. It is anticipated that eight of the nine members of the Monetary Policy Committee (MPC) will continue to support a "gradual" easing of policy. External member Catherine Mann is expected to vote to keep borrowing costs unchanged.

Thomas Pugh, an economist at accounting firm RSM, stated, "Economic growth has significantly slowed, which means the MPC is likely to downgrade its growth forecast for this year. However, inflationary pressures are resurfacing." He predicts a total of four rate cuts this year, down to 3.75%, while the market generally expects three cuts.

The Bank of England currently finds itself in a delicate position: on one hand, strong economic growth and high inflation pressures in the U.S. forced the Federal Reserve to pause rate cuts last week; on the other hand, the European Central Bank cut rates for the fifth time last Thursday and warned that economic growth may stagnate.

Matt Swannell, chief economic advisor at EY Item Club, stated in an interview, "The Bank of England may face a more complex trade-off between inflation and growth in its upcoming forecasts."

On the eve of the central bank's interest rate decision, a report released by EY Item Club on Monday lowered its growth forecast for the UK in 2025 from 1.5% to 1%. The report also noted that inflation could remain above the Bank of England's 2% target for the next 12 months, further intensifying market concerns about the UK falling into a "stagflation trap" characterized by low growth and high inflation.

Swannell remarked, "The UK economy is losing growth momentum by the end of 2024, which means achieving recovery in 2025 will face greater challenges." As a core part of the Labour Party's economic growth plan, business investment will also be impacted. EY has lowered its investment growth forecast from 3% to 2%, primarily due to increased economic uncertainty, rising borrowing costs, and the government's increase in employment taxes.

Last week, Reeves announced a series of planning and regulatory reform measures and approved several infrastructure projects, including the controversial third runway plan at Heathrow Airport, aimed at reviving economic growth.

She emphasized that economic growth will be the government's "top priority" and attempted to reverse the pessimistic economic narrative from the six months prior to the Labour Party's governance while responding to criticism of her October tax-increasing budget. Since the Labour Party won the election in July, the UK economy has been stagnant

In addition to the widely expected interest rate cuts, the Bank of England's monetary policy report in February may not bring much good news. The report will update the assessment of the impact of the Labour Party's £26 billion (approximately $32.4 billion) employer payroll tax increase. Morgan Stanley's UK economist Bruna Skarica stated that recent evidence suggests that the extent to which businesses are passing on more costs to consumers may exceed the Bank of England's expectations from last November.

She indicated that, combined with rising food and energy prices, the Bank of England may raise its inflation forecast for the first half of this year by 0.3 to 0.4 percentage points. Bank of America economists believe that the Bank of England will lower its short-term and long-term growth forecasts "to reflect recent weak economic performance, lack of confidence, and a higher interest rate path." Last November, the Bank of England predicted a 1.5% economic growth for this year, while the current market consensus has dropped to 1.3%.

The Bank of England's practice of using market interest rate paths to construct its growth and inflation forecasts may complicate Thursday's policy communication. The market bet last Friday on three interest rate cuts this year, each by 25 basis points, but the Bank's forecast may be based on the market fully pricing in only two rate cuts. Both scenarios are below the four rate cuts predicted by the Bank last November, and Governor Bailey has previously expressed support for this.

Bank of America economists pointed out that the Monetary Policy Committee (MPC) may "hint at a subtle rebuttal to market pricing" by predicting that inflation will remain below target for the next two to three years. However, this also means that the Bank's growth forecasts based on market paths may underestimate the actual economic outlook for the UK, thereby unnecessarily undermining the policy authority of the Chancellor of the Exchequer.

Former Federal Reserve Chairman Ben Bernanke suggested that the Bank of England should consider using its own interest rate forecasts, as the current practice may "blur the policy intentions the committee is trying to convey." In response, the Bank of England stated that it plans to replace the existing forecasting method with "scenario analysis."