Bank of England May Tolerate Inflation Above 2%, Two Banks Say

(Bloomberg) -- Investors in UK assets are beginning to bet on a de facto increase in level of inflation the Bank of England will tolerate beyond the official 2% target, two major banks warned.

BNY Mellon Investment Management and Bank of America said in separate notes to clients inflation expectations indicated in markets suggest investors think the BOE will let inflation remain above the target for some time, potentially damaging the credibility of the central bank and its goal.

While BOE Governor Andrew Bailey and his colleagues have reiterated their commitment to returning inflation to 2%, there's a growing debate about whether to tweak the target to acknowledge that price increases are likely to remain elevated for some time.

Robert Wood, UK economist at Bank of America, said surveys and market pricing suggest that investors do not expect the BOE to hit its inflation target in the medium-term, unlike in other major economies. 

“The market seems to expect UK inflation on average to exceed the target in the future, in part because it believes the BOE is more inflation-tolerant than other central banks,” Wood said. “This is a challenge to an inflation-targeting central bank we think.”

Britain's inflation rate has eased to 6.7% from as much as 11.1% last year but remains well above the 2.9% rate in the euro area and 3.7% in the US. The BOE is expected to keep rates on hold at 5.25% in tomorrow's MPC meeting as it shifts to a higher for longer approach to borrowing costs.

BNY Mellon Investment Management chief economist Shamik Dhar pointed to higher market-based inflation expectations in the UK that suggests that investors are already starting to question the BOE's commitment to the 2% target. 

“That tells me that at the very least, markets are starting to think, ‘Can we rely on the bank delivering 2% over over longer term time periods?” he said in an interview. The 5-year, 5-year inflation swap rate  — which is used to gauge the market's future inflation expectations — has drifted higher since the start of the year.

Dhar published a note speculating that central banks may allow higher price growth than their official targets. He predicted that interest rates globally will settle at 4.5% to 5.5% in the long run due to stronger inflation with the UK at the higher end of the range.

The warnings come as the BOE battles to restore its credibility on keeping inflation low after accusations that it was slow to tackle to the post-pandemic surge in prices. It has pushed interest rates to a 15-year high of 5.25% to curb inflation, but four of the nine-member Monetary Policy Committee voted to carry on raising borrowing costs at the last meeting in September.

The BOE is expected keep rates unchanged on Thursday, an approach Chief Economist Huw Pill has described as a “Table Mountain” profile in reference to the landmark looming over Cape Town. The implication is that rates will remain elevated for some time instead of spiking higher and then coming down quickly.

However, some rate-setters — including Catherine Mann, Jonathan Haskel and Megan Greene — have expressed concern that the BOE has tightened policy too little, leaving persistent inflation a risk.

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