BOE Set to War-Game Longer Energy Shock While Holding Rates

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(Bloomberg) — The Bank of England is expected to war-game multiple scenarios that reveal how it might react to a prolonged energy price shock this week, as it holds off immediate action on interest rates.

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The Monetary Policy Committee is widely predicted to leave borrowing costs on hold at 3.75% on Thursday as it awaits further clarity on the Middle Eastern conflict. However, its members may use an innovation in their communications to show how they will respond to extended market turmoil as the Iran war comes close to entering its third month.

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Officials believe futures signaling a sharp easing of energy-price pressures may be too optimistic, given the damage done to infrastructure in the Middle East. While that pricing will underpin the BOE’s central forecasts, the bank is likely to acknowledge the possibility of a more negative outcome with damaging implications for growth and inflation.

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“They may have scenarios for energy prices, but will probably also have scenarios for the different extent of second-round effects for a given path of energy prices,” said Michael Saunders, a former BOE rate-setter and senior adviser at Oxford Economics. Scenarios will “play a central role in their decision-making” because of the “wide range of possible outcomes.”

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A prolonged energy shock would likely deliver a further blow to growth and jobs, but also increase the risk of an inflationary feedback loop as workers demand bigger pay rises to compensate and squeezed firms respond by trying to raise prices. BOE hawks could put more emphasis on the latter than the former, with recent data suggesting activity bounced back this month.

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So far, however, the evidence of such effects is limited, as neither employees nor companies have real leverage at a time when firms are cutting jobs and demand is fragile. Money markets are pricing in two quarter-point rate increases this year, but many economists think the BOE is more likely to keep policy unchanged.

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What Bloomberg Economics Says…

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“The Bank of England looks set to hold rates steady in April as it continues to assess the impact of the energy shock on the economy. It is likely to maintain its guidance that it “stands ready to act,” with a minority of policymakers calling for pre-emptive hikes. While those votes might grab the headlines, we think the majority will be concerned about ratcheting up rates when demand is weak. That would be consistent with our view that rates will ultimately remain steady this year.”

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—Dan Hanson and Matt Bunny, economists. Click to read the preview on the Terminal

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Some analysts believe the damage from weeks of conflict in the Persian Gulf will keep energy prices elevated, even if the US and Iran manage to reach a peace deal and the Strait of Hormuz is reopened to commercial shipping.