February BoE MPC Preview: The second turn of the screw
By Jeremy Hawkins, Senior European Economist
January 31, 2022
For a second month in a row, the BoE MPC surprised financial markets with its policy decision in December. Having failed to deliver the widely anticipated tightening in November when an updated Monetary Policy Report (MPR) was hot off the press, the central bank unexpectedly voted 8-1 to raise Bank Rate at its year-end meeting despite the absence of new economic forecasts and only limited fresh data. Both outcomes have left investors somewhat cautious about this week’s decision. However, with inflation still climbing, economic growth picking up and the labour market robust, a 25 basis point hike to 0.50 percent would seem a very plausible market consensus. Thursday also sees the release of an updated MPR.
Having increased Bank Rate by an unusually small 15 basis points in December, the magnitude of any rise this week is uncertain. QE asset purchases were completed on time at the end of last year when the £895 billion ceiling was reached but what happens next to the central bank’s balance sheet will be determined in large part by how quickly interest rates are raised. Anything less than the anticipated 25 basis points would have no immediate implications. However, if the market call is correct, the benchmark rate will hit 0.50 percent, the threshold for suspending the reinvestment of maturing QE assets which, in turn, would facilitate a gradual decline in the stock of QE. Bank Rate will need to reach 1.0 percent before the MPC even contemplates outright asset sales (i.e. quantitative tightening, QT) to shrink its balance sheet more rapidly.
Whatever happens on Thursday, financial markets are discounting a high enough level of Bank Rate later in the year to at least open the door to QT – SONIA (Sterling Overnight Index Average) is seen climbing as high as 1.3 percent by November. That said, there have been few clues as to how far, or fast, the BoE will want to shrink its balance sheet and both factors will have implications for the point at which Bank Rate finally tops out.
Driving the current tightening wave is the ongoing rise in inflation, the speed of which has caught the MPC by surprise. CPI inflation in December easily exceeded the market consensus for a third time in as many months. It also put the annual rate at its highest mark since March 1992 and some 3.4 percentage points above target. Even the underlying gauge saw its strongest reading since June 1992. In its last forecast, the BoE raised its peak inflation forecast to 6 percent in April, coinciding with the scheduled review of the current cap on domestic energy prices (which may be increased by as much as 50 percent). However, recent developments suggest that something closer to 7 percent is much more likely, leaving the current policy stance looking far too accommodative.
The key determinant of just how far interest rates will rise this cycle is wages and the bank is clearly alert to the potential second-round effects on pay rates of sustained high headline inflation. An increasing number of business surveys and even the bank’s own regional agents have found pay rises accelerating as the demand for labour continues to outstrip supply. The latest ONS labour market survey actually showed annual earnings growth slowing to 3.5 percent in November but 12-month rates continue to be distorted by Covid-related effects on the basket sample. More telling is the 2-year rate which helps to strip out such biases and this shows a clear acceleration in both overall and regular (ex-bonus) wages since last August. Achieving the 2 percent inflation target on a durable basis would be highly unlikely if such wage rates were to be sustained.
In fact, the labour market in general has performed very well since the furlough scheme was terminated last September. Employment has been particularly robust and following a record increase in December, payrolls now stand nearly 410,000 or 1.5 percent above their pre-pandemic level in February 2020. Vacancies are also at record levels and the redundancy rate has hit a new all-time low. Fresh evidence that the labour market is so strong gives the bank all the room it needs to tighten again should it see fit.
To be sure, since the last MPC meeting the economy has proved surprisingly resilient. Econoday’s economic consensus divergence index (ECDI) was well above zero over much of the period and in mid-January posted its strongest value since June last year. In recent times the index has been biased up by unexpectedly strong inflation but even after adjustment for this, the real economy ECDI (RECDI) has equalled its highest mark since last May. True, the January flash PMI survey was surprisingly soft but only due to Omicron restrictions that have now been lifted. The BoE was quite gloomy in the November MPR’s assessment of near-term growth but the RECDI suggests it may have to revise up its first quarter growth projection
Amid surging Omicron cases, an estimated 3 percent of the workforce was signed off in late December – the highest figure since comparable estimates began in June 2020 – and a fifth of businesses reported increased cancellations. With December also seeing a hefty 3.7 percent monthly decline in retail sales volumes as new restrictions were introduced, the virus clearly depressed economic activity at year-end. However, if the government is to be believed, the threat from Covid is largely past. Crucially, despite the initial tidal wave of new infections, hospitalisation numbers have remained low and serious cases have even fallen. As a result, most of the remaining restrictions were lifted around the middle of January and just last week mandatory mask-wearing and Covid certification was ended. For now, self-isolation rules for people with the virus are still in place but these are expected to be lifted before the current regulations expire on 24 March. As such, it now looks as if the Omicron threat to economic growth will be significantly less than expected just a few weeks ago.
In summary, economic developments since the MPC’s last meeting are likely to be viewed by most members as warranting a second tightening of policy. The rising risk of a Russian invasion of Ukraine may be one reason for deferring any move but the UK’s dependency on Russia for its energy is quite limited so any impact here ought to be reasonably mild in the absence of a full-blown war. Potentially significantly too, comments from MPC members have been in short supply since the turn of the year – that may well also reflect a general contentment with current market positioning.
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