Oliver Mangan: British economy running on empty with inflation seen peaking at eye-watering 13%

Bank of England forecasts recession for British economy next year, with incomes declining by almost 4%

Surge in gas prices is doing the real damage to disposable income of British households, according to Bank of England.

The Bank of England report last week on monetary policy caught people’s attention by laying bare the impact of soaring energy costs on the UK economy. 

Inflation is now seen peaking at an eye-watering 13% this autumn, up from its previous forecast in May of about 10%, reflecting, in particular, the further very steep increase in the price of natural gas over the summer amid falling Russian exports of the product to Europe.

The hit to real British household disposable incomes is substantial. The bank forecasts incomes will decline by almost 4% in the financial year 2022-23, and as a result, it expects a recession for the UK economy next year, with GDP projected to fall by between 1% and 1.5% in 2023, depending on the course of energy prices. Growth is expected to remain very subdued in 2024-25.

The surge in gas prices is doing the real damage, according to the Bank of England. The prices of Brent crude oil are expected to average close to $100 a barrel this year. This is high, but not that very far above their average of $78 a barrel for the period 2010-2019, or indeed, last year’s level of $79 a barrel.

By contrast, wholesale gas prices in the UK are likely to average 420 pence per therm in 2002, according to the bank. That's an eightfold increase on the prices over the period 2010-20 when they averaged 52 pence per therm. 

The marked fall in the flow of gas from Russia to Europe, and fears of a complete cessation in supply over the winter, are responsible for the enormous surge in global gas prices.

The Bank of England acknowledges the risks around its projections are exceptionally large. Thus, it produced a number of alternative economic scenarios, but even then all its projections show very high inflation in the near-term and a fall in British GDP next year.

However, it forecasts inflation will decline sharply over the medium term under all the scenarios, caused by a combination of static or lower energy prices and recessionary conditions in the economy. 

Indeed, inflation is seen declining to below the Bank of England's 2% target by the end of 2024 and falling even further, to under 1%, in 2025. All this makes it very challenging for the bank to set monetary policy at the present time.

The bank raised interest rates by 50 basis points, or half a per cent, at last week’s meeting, to 1.75%, marking an acceleration in the pace of increases from the hikes of a quarter point seen since December. 

The bank warned that policy is not on a pre-determined path and the 50 basis point hike does not imply that rates will now be raised in 50 basis point steps at forthcoming meetings. 

Markets expect the bank to raise rates to a peak of about 3% by early next year. The peak could turn out to be higher or lower. 

The surprising thing, though, given the bank’s medium-term projections for growth and inflation, is that markets see rates being cut only modestly thereafter to a floor of 2.25% in 2024-25. 

Interest rates will go much lower by then if the bank’s economic projections are anyway close to the mark.

• Oliver Mangan is chief economist at AIB