Financial markets have become very used to the BoE MPC raising Bank Rate. It has done so at every policy-setting meeting since it began the current tightening cycle last December and expectations are that Thursday’s announcement will make it seven out of seven. Even so, signs of a widening split between the MPC’s doves and hawks mean that the size of the increase is much less certain. Complicating matters a good deal more is the government’s newly announced Energy Price Guarantee. This will cap household energy bills for the next two years and, potentially significantly, lower the near-term inflation outlook while at the same time probably providing a boost to inflation over the medium-term. A 50 basis point increase would put Bank Rate at 2.25 percent, its highest level since December 2008 and would be only the second time that the bank has moved this aggressively since February 1995. A 75 basis point tightening would be the largest since so-called “Black Wednesday” in September 1992 when the bank tried, and failed, to keep the pound in the exchange rate mechanism (ERM) of the European Monetary System (EMS).
At the August meeting, the sole dissenter calling for only a 25 basis point hike was Silvana Tenreyro, probably the most dovish on the MPC. Recent comments from her suggest she still has little enthusiasm for a sharper move, emphasising instead that a widening output gap and rising unemployment are likely to weigh heavily on domestic inflationary pressures. She also pointed out that as Bank Rate moves closer to the neutral rate, smaller changes would be all the more appropriate in order to avoid excessive tightening that would put added downside pressure on the real economy. However, for the likes of Catherine Mann, one of the most hawkish members, the big worry is that the action taken so far has not tempered inflation expectations. This suggests that she might fall into the 75 basis point camp. Consequently, another, possibly wider, split vote on rates is very likely. In any event, financial markets still expect 3-month SONIA (Sterling Overnight Index Average) to climb sharply over coming months, rising from about 2.6 percent currently to nearly 4.0 percent by year-end and above 4.5 percent in the middle of 2023.
This week’s meeting will also see a decision on the proposal to begin outright sales of QE gilts. So far, the only active QT has been restricted to corporate bonds which are in the process of being gradually whittled down from a peak of £19.99 billion with a view to being fully unwound no earlier than the end of 2023. However, subject to a confirmatory vote, the bank is aiming to sell £10 billion of the gilts every quarter as part of its plan to shrink its balance sheet by £80 billion a year. That said, sales will be subject to economic and market conditions being judged appropriate and that could now be an issue should investors struggle to digest the huge additional issuance needed to fund the government’s emergency energy support scheme. This aside, any shift to a more broad-based QT programme would of its own accord tighten the policy stance still further.
Crucial to the future interest rate profile is inflation but, in the wake of recent developments in the energy markets and the policy responses at home and abroad, the outlook has become even more uncertain than usual. Russia’s decision to essentially turn off its gas tap to Europe has provided a fresh underpinning for energy prices but G7 plans to cap prices and, in particular, the UK government’s new price freeze all make for a very complicated picture. The bottom line though, is that headline UK inflation, recently predicted by some to breach fully 20 percent in January, is now likely to be much lower over the near-term. Indeed, even the BoE’s August prediction of a 13 percent rate next month when the current domestic energy price cap had been due to be lifted by some 80 percent, is probably several percentage points too high. That said, the new emergency fiscal package – estimated to cost around £170 billion or more than twice the size of the Covid furlough programme – is easily large enough to boost inflation over the medium-term. Against this backdrop, determining the appropriate stance of policy becomes all the more complex and inflation expectations an increasingly important guide.
To this end, the new BoE/Ipsos survey released just last week found another rise in 1-year ahead household inflation expectations. At 4.9 percent, the latest reading was up from 4.6 percent in May and a new record high. However, reflecting worries about the economic outlook, the 5-year ahead view was actually trimmed from 3.5 percent to 3.1 percent, its first fall since May 2021 and below the survey’s long-run average. Elsewhere, August’s Citi/YouGov poll put expectations for average inflation over the next five to 10 years at an all-time high of 4.8 percent. This was up from 3.8 percent in July which also made it the steepest increase since the data were first collected. At the same time, businesses are expecting a further acceleration in wage growth. The BoE’s August Decision Maker Panel (DMP) found firms expecting wages on average to climb 5.5 percent over the coming year. This was up from 5.2 percent in July and 4.4 percent in May. Of note too, based on the BoE/Ipsos survey, public satisfaction with the central bank’s control of inflation also fell to its lowest mark since 1999. This could hardly have come at a worse time for the central bank with talk that the new Truss government may want to tinker with BoE independence. Adding to the inflation problem too is the weakness of sterling, the currency losing 4.4 percent versus the dollar in August to realise its worst month since late 2016 in the wake of the Brexit referendum. Indeed, current levels are amongst the lowest in the last 37 years. The inflationary boost from the exchange rate will be one factor in any vote for 75 basis points on Thursday.
Meantime, the real economy is creeping towards recession. Second quarter GDP shrank 0.1 percent versus the January-March period and July’s very modest 0.2 percent monthly gain only slightly dented June’s hefty 0.6 percent contraction. In particular, the goods producing sector, where output has already fallen in three of the last four months, will need to have a decent August and September if it is to avoid a second successive quarter of negative growth. However, the labour market remains very tight. Employment is still expanding and unemployment is barely enough to fill all the outstanding vacancies which continue to chalk up record highs. As such, it is little surprise that businesses see little chance of any significant easing in wage pressures near-term. Even so, with regular real wages declining at the fastest rate on record, households are having to cut back. Discretionary retail sales volumes have fallen in four of the last five months and in August were at a level not seen since the Omicron wave around the turn of the year. Private sector domestic demand is weak.
Indeed, both businesses and, in particular, consumers are becoming increasingly worried about the future. Most measures of household sentiment indicate serious weakness – the OECD index declining every month since July last year and the GfK gauge registering fresh all-time lows in each of the last four months. The deterioration in industry has been less marked but the PMI’s composite output index has shed more than 11 points since March and in August posted its first sub-50 reading since February 2021. The government’s new fiscal package may offer some support but in terms of a recession, it would seem to be more a case of when and for how long rather than if.
In fact, the latest figures suggest that recession could arrive sooner than the BoE expects. Although much of the data reported in August were on the firm side of expectations, September’s releases have been surprisingly weak. The UK ECDI, which measures how recent economic activity in general have performed versus market expectations, has slumped to minus 40, matching its worst reading in half a year. While hardly optimistic in the first place, forecasters have been surprised at the speed with which the economy is slowing. However, with policy so focused on containing inflation, this will not prevent another move on interest rates this week.
Whatever the bank decides to announce on Thursday, it is unlikely to feel overly confident that it has done the right thing. As it has freely acknowledged for some time, the economic outlook has become highly uncertain and the latest developments surrounding energy supplies and prices have only made it more so. Inflation is high enough that Bank Rate must surely be raised again but since its peak may now be well below what previously seemed likely, both the appropriate speed and extent of future tightening are all the harder to judge.