The medium-term inflationary impact of Putin’s war is not obvious

Near-term, higher prices of energy, precious metals and agricultural goods will push up consumer price inflation even further above the BoE’s 2% target – to a peak of c8% in April. Further out, however, the impact is less clear. On the one hand, the spectacle of a major European conflict could trigger significant consumer caution, depressing demand and prices. If the war tips the UK into a shallow technical recession (unlikely but not impossible) initially high inflation could give way to a bout of disinflation in which inflation actually falls below the BoE’s 2% target. On the other hand, even higher prices could feed into higher wage settlements – leading to more persistent inflation.

Less than three weeks after Putin ordered his troops to invade Ukraine, it is too early to say which outlook is more likely. By the time of the Monetary Policy Committee (MPC) meeting in May, the BoE will have a much clearer view upon which to judge the correct course for policy. To raise rates before the balance of inflation risks becomes clearer would be to act in haste and risk a policy error.

While there is a clear risk that the BoE will hike on Thursday by 25bp to take the bank rate to 0.75%, we think that there is a higher chance that policymakers will surprise markets by holding steady. In what will probably be a split vote, policymakers will likely emphasise that rates may need to rise by more than previously signalled from May onwards in case demand remains robust through Putin’s war and medium-term inflation risks worsen.

Interest rate markets – a recent history of surprises

According to the closely watched OIS (overnight index swaps) market, the BoE is certain to hike the bank rate to its pre-COVID level of 0.75% on Thursday. But while such markets offer a useful guide to market expectations for rates, their recent record of predicting BoE moves is patchy at best. In early 2021, OIS curves had signalled the BoE would go for a negative policy rate – which never happened. The day before the BoE’s 4 November 2021 meeting, the market saw a 58% probability of a hike – but the BoE kept rates unchanged. And most recently, the day before the 16 December 2021 meeting, the market saw a 76% probability that the BoE would keep rates on hold – the BoE hiked by 25bp.

In a recent speech, the BoE’s chief economist Huw Pill said that ‘Under our baseline paths for wages and energy prices, our published scenarios suggest that leaving Bank Rate unchanged at 0.5% indefinitely would – unsurprisingly – leave inflation above our 2% target at the policy-relevant horizon, whereas following the market-implied path to 1.2% by the end of this year would have left inflation somewhat below target. I leave it to you to draw any implications for where the MPC sees the path of Bank Rate headed’. On 14 March, OIS markets expected the BoE bank rate to reach 2.0% by end-2022 – probably twice the year-end rate level that Pill meant to signal. If the net effect of Putin’s war on medium-term inflation is neutral, then the BoE’s February guidance still applies – even if inflation will surge by more than expected in the coming months.

Policy outlook – continued gradual tightening

As our base case, we expect Putin’s war to badly hurt UK economic performance during Q2 and through the early part of Q3 before healthy consumer and business fundamentals reassert themselves and lift momentum through H2 2022. In such a scenario, we look for two more hikes in 2022 (May and August) and for the BoE to begin active bond sales as part of its quantitative tightening programme in November. We expect two hikes per year in 2023 and 2024 to take the bank rate to 2.0% by end-2024.

The risks around our BoE calls are two-sided and will depend upon how the war impacts demand and supply at home and abroad in coming months. If the BoE hikes this week, we would expect a material slowdown in the pace of any further hikes thereafter. This would fit with the BoE’s guidance in February that OIS markets seem to anticipate more hikes than policymakers believe are necessary to return inflation to target. If the BoE’s rate hikes match its guidance, the market will face a dovish surprise at some point this year. In our view, it would be better for this to happen now when the economy faces a potentially severe shock that will depress growth and hurt confidence.

Kallum Pickering
Senior Economist, Director

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