December BoE MPC Preview: An Omicron conundrum
By Jeremy Hawkins, Senior European Economist
December 14, 2021
To say that the BoE MPC’s November decision came as a surprise to financial markets would be to put it mildly. A succession of hawkish comments from the central bank in the run-up to the announcement had left investors convinced that a hike in Bank Rate of at least 15 basis points was a done deal. Consequently, the subsequent clear-cut 7-2 majority vote to leave policy on hold was met with heavy criticism and seriously damaged the BoE’s communication credibility. It also meant that heading into this Thursday’s announcement, an earlier market consensus for a 15 basis point increase in rates lacked any real conviction. As it is, the subsequent arrival of the Omicron variant has undermined such speculation even further. While rates could certainly still go up this week, most forecasters now do not see the policymakers making any adjustment until more is known about the effects of the latest virus mutation. And that probably means waiting until at least the next Monetary Policy Report (MPR), due in February 2022.
In fact, the arrival of Omicron has reduced tightening speculation in financial markets quite significantly versus just a couple of weeks ago and rates are now seen peaking both somewhat lower and slightly earlier than previously anticipated. If this revised view is correct, the 1 percent Bank Rate threshold needed to open the door to quantitative tightening (QT), that is asset sales as opposed to asset purchases under QE, will also be reached around three months later than thought likely earlier.
Meantime, the current QE programme has nearly run its course. Having seen overall purchases reach almost £890 billion last week, the £895 billion fund should be fully utilised just before the end of the month, in line with the original proposals. It is unlikely to be increased again unless Omicron hits the economy much harder than currently assumed. Under the exit strategy laid out in August, the BoE will next seek to keep its balance sheet stable until Bank Rate reaches 0.5 percent. At that point, it will stop reinvesting maturing assets and so facilitate a gradual decline in the stock of QE. A 1.0 percent Bank Rate is the lowest point at which it will contemplate QT but, unlike the 0.5 percent reinvestment level, this should not be seen as an automatic trigger for asset sales. Although Governor Bailey has stressed that a reduction in the balance sheet should not be regarded as a substitute for higher interest rates, it should still help to reduce the peak in the rate cycle by supporting the tightening process. However, there have been few clues as to how far QT might go.
The MPC has been surprised by the rapid acceleration in inflation and while still viewing the rise as only temporary, it is clear that confidence in achieving the 2 percent target over the medium-term is not what it once was. The November CPI will be released on Wednesday and is expected to show the headline rate climbing to fully 4.7 percent, which would be its highest mark since November 2011. In any event, the October report already put the yearly rate at a heady 4.2 percent, well above market expectations and more than double the target. Much of the acceleration continues to be attributable to sharply rising energy costs and combined, the housing and utilities and transport subsectors contributed fully 2.3 percentage points to October’s headline print. However, the core rate, which excludes food, alcohol, tobacco and energy, is trending steadily higher too. At 3.4 percent, October’s outturn was the strongest since April 2011. Ominously too, the BoE’s quarterly survey of inflation expectations released just last week found a jump in the year-ahead rate expected by households from 2.7 percent in August to 3.2 percent (although less worryingly, the long-term rate was up just a tick at 3.1 percent).
Much of this year’s surge in underlying inflation can be traced to developments in core producer prices and (regular) wages. The chart above shows a simple Ordinary Least Squares (OLS) regression explaining the acceleration in terms of these variables and while hardly a perfect fit, the relationship is clear enough. It also warns of still higher inflation to come. More medium-term, much will depend upon how the labour market, and hence, wages respond to the withdrawal of fiscal support.
A key factor behind the MPC’s November decision to leave policy on hold was concern about how jobs would be impacted by the termination of the government’s Coronavirus Job Retention Scheme (CJRS) at the end of September. However, so far, the news has been positive. According to the experimental Pay As You Earn Real Time Information data, payrolls have continued to expand at a healthy clip, rising a cumulative 331,000 in October/November and are currently more than 424,000 above their pre-pandemic level. In a similar vein, vacancies are at record highs and redundancies at their second lowest level since the first quarter of 2019. Importantly though, wage growth, a key input into BoE policy, is still falling from the Covid-distorted highs seen earlier in the year. That said, at currently 4.9 percent and 4.3 percent respectively, the rates for both overall and regular earnings remain firm enough to raise suspicions of possible second-round effects from high inflation and cast doubt about the chances of achieving the 2 percent inflation target sustainably.
In fact, for much of the time since October economic activity in general has outperformed expectations – Econoday’s economic consensus divergence index (ECDI) has been very largely in positive surprise territory. However, the headline index has at times been biased up by unexpectedly strong inflation and after adjustment for this, the real economy ECDI (RECDI) has seen periods of significant downside shocks as shown in the graph above. Indeed, following much weaker than anticipated October GDP the RECDI dropped to minus 28, its weakest reading since early September. This may be a factor that helps to sway Thursday’s decision in favour of no change.
But the tallest hurdle in the path of higher interest rates is Covid. Even before Omicron was detected, UK cases had been climbing steeply from already elevated levels. Consequently, the discovery last month of the new variant is seen as a real cause for concern. The latest data have tentatively suggested that current vaccines do provide some protection against Omicron but its transmissibility is ominously high – cases in the UK have been doubling every 2-3 days and the mutation already represents more than 20 percent of cases in England. Indeed, the government is now warning about a probable tidal wave of cases over coming weeks and has set itself a new target of offering boosters to all adults who want one by the end of this month. With the vaccination rate slowing and earlier immunity beginning to fade, the booster programme will be key to how the economy performs as newly imposed and prospective additional Covid restrictions threaten to dampen growth. For now, the government is still insisting that there will not be another lockdown but either way, Omicron adds to considerable uncertainty about the economic outlook.
Against this backdrop, investors are not surprisingly unsure about what the MPC will do this week. Prior to the arrival of Omicron and the unexpectedly weak October GDP report, there seemed to be quite a strong conviction that interest rates would be going up but that has now changed. The final decision is likely to be very finely judged and even a vote for no change would not stop speculation about a tightening next February. In terms of this Thursday, some might take comfort in the fact that Bank Rate has only been increased once in December in the last 45 years and never since the BoE gained independence in 1997. But then these are very unusual times so historical precedent is probably of only limited usefulness anyway. All of which leaves financial markets highly uncertain and likely to react to whatever the central bank says. There will definitely be no shortage on interest going into Thursday’s announcement.