Perhaps, like the infamous Bobby Ewing dream sequence in Dallas in the 1980s, when an entire season of the American TV show was revealed to have been just a dream, we should pretend the Iran war never happened. <\/p>\n
Fragile ceasefire or not, the situation we are in now economically \u2014 compared with before February 28, when the US-Israel war on Iran began \u2014 is much worse. Sadly, it was not all a dream, or even a nightmare.<\/p>\n
Historians, including economic historians, will be feasting on the consequences of the past few weeks \u2014 the great miscalculation \u2014 for years if not decades. For now, it is one thing to comment on this, another for households and firms to have to deal with it. This also applies to a group that does not elicit much public sympathy: the economic forecasters.<\/p>\n
Already this year, the UK\u2019s official forecaster, the Office for Budget Responsibility (OBR), has had a coach and horses driven through its latest economic projection, in March, by the Iran war. The OBR team had all but completed their work when the conflict began. Now their counterparts at the Bank of England, their last forecast in February consigned to history, are charged with putting together a forecast that will come to fruition at just around the time that last week\u2019s agreed and fragile ceasefire is due to come to an end.<\/p>\n
The Bank\u2019s economists are unlucky. Its quarterly monetary policy reports, each of which includes a full updated forecast, are usually published in February, May, August and November. But with local elections on May 7 this year, the quarterly forecast for that month, and the accompanying decision by the Bank\u2019s interest rate-setting monetary policy committee (MPC), has been brought forward a week to April 30. So it\u2019s still very much in the corridor of uncertainty.<\/p>\n
These forecasting exercises are not just of academic interest. The MPC has historically been more likely to raise or lower rates, and send interest rate signals, when publishing a new forecast.<\/p>\n
The Bank\u2019s April forecast will look very different. In February, it expected inflation to drop to close to the official target, averaging 2.1 per cent in the April-June quarter and staying at about the 2 per cent target after that.<\/p>\n
It also gave a clear steer on interest rates, saying: \u201cOn the basis of the current evidence, Bank Rate is likely to be reduced further.\u201d<\/p>\n
That evidence is, of course, no longer current. Inflation will not be close to the official target in this quarter. As a first stab at estimating the inflationary impact of the war, the MPC, in holding interest rates at 3.75 per cent on March 19 (against cast-iron expectations of a cut before the war), suggested that inflation would average 3 per cent in the current quarter, rising further to 3.5 per cent in the July-September quarter.<\/p>\n
That was based on what was then known, and while in the intervening period there have been suggestions that the oil price could hit $150 or $200 a barrel (there always are), it would be hard to argue that anything has changed for the better.<\/p>\n
It was always expected that the war would wind down after a while. Professor Jonathan Haskel, a former MPC member, points out that the OECD forecast late last month \u2014 which significantly downgraded UK growth, to 0.7 per cent, and increased its UK inflation forecast to 4 per cent \u2014 was based on a gradual return of oil prices to pre-Iran war levels, starting in the middle of the year.\u00a0<\/p>\n
You can see why, apart from the hawkish language employed by the Bank in holding interest rates last month, markets decided there would be no rate cuts this year, against earlier expectations of two or three.<\/p>\n
For the MPC to cut this year, it would have to do so with inflation running above 3 per cent, perhaps quite a bit more if the OECD is right. In theory, there is nothing to stop this if the Bank is convinced that inflation is going to fall like a stone over the following two years. But in presentational terms, it would be more than a little awkward.\u00a0<\/p>\n
Markets quickly replaced those two or three expected cuts with a similar number of hikes, though those expectations have been pared back in the wake of the ceasefire. But a rate increase, if only one quarter-point move, is still seen as more likely by markets than a cut.<\/p>\n
One of the most common comments I get is that the Bank should not be thinking of raising rates in response to an external energy shock that will put up inflation only temporarily, at the same time hitting demand hard.<\/p>\n
I have some sympathy with that and, until relatively recently, central banks usually opted to \u201clook through\u201d any increase in inflation due to a shock of the kind we have seen from the Iran war.<\/p>\n
The Bank and other central banks had their fingers burned four years ago, though, when after emphasising the \u201ctransitory\u201d nature of post-pandemic inflation, they were caught out by the energy shock caused by the Russian invasion of Ukraine. Once so-called second-round effects started to emerge, particularly stronger wage growth \u2014 hardly surprising in the context of a very tight labour market and near 20 per cent food price inflation (and 11 per cent general inflation) \u2014 the Bank had to act aggressively to head off the danger, raising interest rates to more than 5 per cent.<\/p>\n
We are not in that situation now. The labour market is much looser, the economy weaker, and inflation is not heading to the heights we saw in 2022. I still think it will take a lot to persuade the Bank to put up interest rates, if only modestly, though MPC members insist that they will do so if it is necessary.<\/p>\n
Are there any circumstances in which rates could still be cut later this year, as once expected?\u00a0<\/p>\n
Crude oil prices would have to fall by more than they have done so far to allow a rapid return to prewar petrol and diesel prices, and the bottlenecks in the supply of refined products would have to be successfully tackled. International gas prices, similarly, need to fall quite sharply in the coming weeks so that the energy price cap can fall back in October, allowing an improved inflation trajectory.<\/p>\n
These things could happen, alongside a weakening of the economy that some MPC members might see as persuasive in voting for rate cuts. They are, however, a long shot, maybe even a case of \u201cdream on\u201d. Whatever happens between now and the end of the month, the Bank seems prepared for the many consequences of this energy shock to take quite a time to feed through. <\/p>\n
That does not mean hiking rates, but it does mean cuts are off the menu. And that will be a big disappointment for many.<\/p>\n
PS<\/p>\n