By Jeremy Hawkins, Senior European Economist
June 14, 2022
Another BoE MPC announcement, another hike in interest rates. Having already raised Bank Rate at each of the last four meetings, financial markets seem convinced that Thursday’s statement will make it five out of five, making it the steepest sequence of increases in quarter of a century. The market consensus is another 25 basis point rise that would put the benchmark rate at 1.25 percent, its highest level since January 2009, but there is significant speculation that the pace of tightening might be stepped up.
Even before looking at the data, the chances of another increase this month had already been boosted by the May MPC decision which saw three members (Jonathan Haskel, Catherine Mann and Michael Saunders) defy the majority vote and call for a larger 50 basis point move. As it is, 25 basis points was still enough to lift Bank Rate to the 1.0 percent threshold required for outright asset sales (active QT). However, last month the bank simply indicated that it would update its QT strategy in August. It did though note that it would be commencing sales of its QE corporate bonds in September with the aim of fully unwinding the stock no earlier than the end of 2023. In practice, there is probably a good deal of uncertainty on the MPC about how effective QT might be as a tightening tool anyway. Saunders for one believes that there is good reason to expect that the effect on the economy from selling gilts would be smaller than that of purchases and has indicated that he is not in favour of gilt sales being used as an active policy tool.
The fact that active QT has not yet begun has left financial markets assuming that interest rates will shoulder the burden of policy tightening for the time being. As such, a string of further rate hikes is anticipated over coming months, pushing SONIA (Sterling Overnight Index Average) above the 2 percent mark by September. With no meeting in July, it will require at least one 50 basis point rise to get there on that schedule. Assuming only 25 basis points this Thursday, the May CPI (due 22 June) is likely to have an important say in the pace of tightening immediately after.
As it is, inflation is well on its way to reaching the 10 percent-plus fourth quarter peak forecast by the bank in its May’s Monetary Policy Report (MPR). The April CPI was much stronger than expected and showed further signs that price rises are becoming increasingly broad-based. Moreover, since then energy prices, already boosted by the war in Ukraine, have responded to EU plans to wean itself off Russian oil as soon as possible. This has helped to push petrol prices to record highs and could see the energy regulator’s cap on domestic household energy bills, already raised more than 50 percent in April, increased by a further 40 percent in October. If so, headline inflation could climb significantly higher near-term, especially with the dollar so strong and the pound susceptible to domestic political instability.
The labour market is also now very tight, adding to upside pressure on wages. The ILO’s measure of unemployment has been falling quite steadily since the end of 2020 and, for the first time on record, slipped below vacancies last quarter. Demand is outstripping supply and firms are having to bid up pay rates in order to attract a diminishing pool of available workers. Also driving the upswing in pay are households’ inflation expectations. According to the May Citi/YouGov survey, households thought inflation in five to 10 years’ time would be 4.2 percent, unchanged from the April survey and so still more than double the BoE’s inflation target. For the coming 12 months, the rate even edged a tick higher to 6.1 percent. Such findings will not sit at all well with the MPC’s hawks.
On the other hand, while the real economy superficially looks to have had a decent first quarter, growth has slowed sharply since the start of the year. Following January’s 0.7 percent monthly advance, real GDP was only flat in February and contracted in both March and April. There is now a very real chance that the second quarter print is negative. Households are clearly struggling as price rises outstrip wage growth and what promises to be one of the most severe squeezes on consumer budgets in living memory threatens to seriously undermine spending over coming months. Looser Covid restrictions provided an initial boost around the turn of the quarter but discretionary retail sales still fell in April and purchases of food have declined in five of the last six months. Some help should come from the government’s new cost of living support package announced last month. However, while this will provide every household with a £400 discount on energy bills and inject around £15 billion into the economy this year, with confidence levels so low, its impact on overall consumer activity may be only limited.
To be sure, surveys of business and consumer sentiment have deteriorated significantly over the last few months. According to the OECD, consumer confidence slumped to a record low in April while business sentiment saw its weakest level in a year. The latest PMI report similarly pointed to a marked deceleration in business activity; the headline composite output index in May posting one of the steepest monthly falls on record, albeit remaining above the 50-expansion threshold. Amongst the G20 bloc of countries, the OECD now expects the UK to be the weakest performing economy after only Russia next year.
Still, having undershot market expectations in late April and early May, the majority of the data released since the last MPC meeting have been surprisingly strong – Econoday’s economic consensus divergence indicator (ECDI) has been above zero for most of the period. This indicates that even if overall economic activity has decelerated, it has not done so any faster than already expected. This should help to smooth the path to higher interest rates on Thursday and might strengthen the conviction of some MPC members that a 25 basis point hike would be too small.
In fact, with the real economy and prices heading in completely different directions and clear disagreements on the MPC about the appropriate pace of tightening, this month’s MPC vote could be very messy. If only for the sake of policy credibility, another rate hike seems unavoidable with inflation so far above target but even raising Bank Rate to 1.5 percent on Thursday would probably leave financial markets expecting a lot more to come.