November BoE MPC Preview: The first turn of the monetary policy screw
By Jeremy Hawkins, Senior European Economist
November 2, 2021
In sharp contrast to September’s BoE MPC meeting, financial markets now seem convinced that Bank Rate will be hiked at least once, if not twice, before the end of the year. Indeed, the market consensus is a 15 basis point increase to 0.25 percent at this week’s announcement which, if correct, would be the first time that the UK central bank has raised its key interest rate since August 2018. Adding to the chances of a move Thursday will be a new Monetary Policy Report that typically provides the fundamental justification for any change in policy.
Following hawkish comments from a number of MPC members (notably including BoE Governor Andrew Bailey) in late October, sentiment in financial markets has shifted dramatically and quite aggressive tightening is now discounted through 2022 – the 3-month short-£ contract is pointing to close to a 1.5 percent Bank Rate by year-end. Previously the bank thought that above target inflation would be only temporary but it appears that the majority of decision makers now see a real risk of inflation remaining high for much longer unless policy is tightened. Indeed, late last month Chief Economist Huw Pill said inflation could top 5 percent early in 2022. The big worry would seem to be a de-anchoring of inflation expectations that boosts wage demands. According to the Citi/YouGov survey, household inflation expectations for the year ahead jumped from 4.1 percent in September to 4.4 percent last month, the highest reading since 2008. As it is, the government has already announced an increase in the main National Living Wage by 6.6 percent, effective next April.
Still, a unanimous vote in favour of raising rates is not a done deal. For a start, recall that September’s MPC vote on Bank Rate was 9-0 in favour of no change. Since then, both Silvana Tenreyro (a leading dove) and Catherine Mann (yet to be determined) have signalled that they do not think that the conditions are yet right; the former even warning that higher borrowing costs could be self-defeating. Moreover, it is very unclear how high Bank Rate might go. The current QE programme is scheduled to end in December, thereby removing the £3.4 billion of additional liquidity that the bank has been supplying every week on average since May. On top of that, under the BoE’s exit strategy, even the reinvestment of maturing QE assets will cease once Bank Rate has reached 0.5 percent while outright asset sales (i.e. quantitative tightening, QT) can commence once the 1.0 percent level has been hit. In other words, policy tightening via higher interest rates will be supported by QT, reducing the extent to which Bank Rate needs to be raised.
CPI inflation surprisingly fell in September but at 3.1 percent and 2.9 percent respectively, both the headline and core rates were still well above the 2 percent medium-term target. Moreover, underlying wage growth appears to be responding to a shortage of skilled workers in some industries and producer price inflation is running at a decade high. Crucial to the BoE’s apparent U-turn has been the dramatic rise in energy prices, notably the soaring cost of gas which accounts for around 40 percent of the UK’s energy consumption. UK natural gas prices have more than doubled since the start of the year due to a combination of factors that has both lifted demand and reduced supply. Energy prices are volatile and could yet reverse a portion of these gains should Russia increase supply as promised. However, with winter approaching and inventories low, rising demand argues against any significant lasting decline.
In any event, higher borrowing costs will not help to bolster supply which continues to be severely hampered by serious blockages in global and domestic supply chains as well as shortages of raw materials. Real GDP growth in the three months to August was 2.4 percent, down from 4.2 percent previously and its weakest rate since in the period ending in April. Total output was still 0.8 percent below its pre-pandemic level and all of the major sectors remained short of their respective pre-crisis levels. Moreover, the consumer sector is cautious. Retail sales fell for a record fifth straight month in September, leaving volumes at their lowest level since March and third quarter spending some 3.6 percent below its second quarter mark. It may well be that higher prices are already causing consumers to retrench.
Also arguing against aggressive tightening is the labour market. The jobless rate has risen by much less than originally expected during the pandemic but, despite trending lower throughout 2021 to date, is still above its pre-crisis level. To be sure, the rate would be a lot higher but for government support programmes. However, the key Coronavirus Job Retention Scheme (CJRS) was terminated at the end of September and some 1.3 million workers were still receiving furlough payments in August. Previously, the BoE has insisted that it wanted to see how the labour market would adjust to the reduction in fiscal support so hiking Bank Rate as soon as this week would seem somewhat contradictory.
Since September’s policy deliberations, the economic data have been mixed versus market expectations with both surprisingly firm and weak reports on the real economy and inflation. At 11, Econoday’s economic consensus divergence index (ECDI) shows that overall economic activity is currently expanding a little more quickly than generally anticipated but not significantly so. As such, inflation apart, the data do not lean conclusively in favour of a shift in policy.
The other big issue is still Covid which came back with a vengeance in October as new cases climbed to levels not seen since mid-July. The latest data have tentatively pointed to a renewed decline but with the vaccination rate slowing and earlier immunity beginning to fade, the booster programme will probably need to be stepped up if winter is not to see another dangerously high spike. The government insists that there will not be another lockdown but rising self-isolation measures can only further dampen output and so give another push to inflation.
Against this backdrop, any increase in Bank Rate over coming months is likely to be only limited. Clearly, the supply bottlenecks that, in September, the MPC thought would “prove fleeting” and “sort themselves out” have been much more resilient than expected. Nonetheless, higher interest rates will not boost supply and, with mortgage rates already on the way up, could damage the recovery in demand. The first turn of the monetary screw may be just around the corner but overall tightening could well be less than financial markets discount and policy is set to remain loose over the foreseeable future.