By Jeremy Hawkins, Senior European Economist
March 15, 2022
Having already just seen policy tightened at back-to-back meetings for the first time since 2004 and despite the crisis in Ukraine, investors seem fairly certain that Thursday’s BoE MPC announcement will deliver a third successive hike in interest rates. If the consensus forecast is correct, a 25 basis point increase would put Bank Rate at 0.75 percent, matching its highest level since February 2000.
February’s 25 basis point increase was very nearly more aggressive as MPC members Jonathan Haskel, Catherine Mann, Dave Ramsden and Michael Saunders all wanted a larger 50 basis point move. In itself, this bolsters the likelihood of another hike this week. Since then, arch hawk Saunders has intimated that because rates did go up again last month, he may favour a smaller rise this time around. Either way, in the main recent comments coming out of the bank suggest that there is currently another clear majority in favour of additional tightening. However, if the market call is accurate, there will be no immediate implications for QE, or more accurately now, quantitative tightening (QT).
The £895 billion QE asset purchase programme was completed on time at the end of last year and February’s 25 basis point rise put Bank Rate at the threshold needed to suspend the reinvestment of maturing QE assets. This is now allowing the bank’s balance sheet to shrink according to natural run-offs, worth nearly £28 billion this year and more than £70 billion next. However, absent a change in forward guidance, outright gilt sales will not begin until the benchmark rate has reached at least 1.0 percent (although the £20 billion QE stock of corporate bonds is expected to be fully unwound by the end of next year).
Currently, financial markets are pricing in SONIA (Sterling Overnight Index Average) reaching the 1 percent mark by May and nearly 2 percent by November. The degree of tightening is significantly more than discounted shortly before February’s MPC meeting and much the same as just before Russia moved into Ukraine. At that time, a number of BoE officials, including Governor Bailey, pushed back against what they thought to be overly aggressive market expectations, pointing out that the then 2 percent implied high for Bank Rate would leave inflation well below its 2 percent target over the medium term. However, with the inflation outlook now markedly worse, the eventual peak to borrowing costs is much more uncertain.
Last month, the energy regulator, Ofgem, raised the cap on domestic fuel bills by fully 54 percent, a change that will come into effect next month. The adjustment was already incorporated in the forecasts contained in the BoE’s February Monetary Policy Report (MPR) and lay behind another upward revision to the peak inflation projection to just over 7 percent in April. However, since then, the Ukraine crisis has seen crude oil prices briefly hit 14-year highs and forecourt prices early last week posted a record daily rise. The oil market is highly volatile but at the time of writing, Brent is still trading above $100/barrel. This compares with around $80/barrel at the time of the February MPC meeting. With many other commodity prices having similarly climbed steeply, the BoE’s near-term inflation projection could easily prove too low by several percentage points. As it is, headline CPI inflation in January was already running at some 5.5 percent, its highest post since comparable data were first compiled in January 1997. A core rate of 4.4 percent was the strongest-ever print but, ominously, still nearly 5 percentage points short of its factory gate price counterpart.
To make matters worse, inflation expectations are on the way up. The quarterly BoE/Ipsos survey released just last week showed household inflation expectations for the year ahead jumping from 3.2 percent in November 2021 to 4.3 percent in February, just 0.1 percentage point below their all-time high. The longer-term median was markedly lower at 3.3 percent but this was still up from 3.1 percent and its strongest print since February 2020. In the same vein, the monthly Citi/YouGov survey put the year-ahead forecast at some 5.6 percent, a 0.8 percentage point increase versus January and a new record high. Similarly, the expectation for the rate over the next five to 10 years rose from 3.8 percent to 4.1 percent, matching the record peak posted in June 2011. Such readings will not sit well with the MPC’s hawks.
For the central bank, the big concern is that rapidly rising prices will translate into faster wage growth. To this end, a recent survey by the BoE’s own regional agents found firms expecting to boost wages 4.8 percent next year, easily high enough to ring a few alarm bells on the MPC. However, the picture is unclear as other, private sector, reviews have put the rise closer to 3 percent. In any event, the tightness of the labour market must make for upside risk. Employment has continued to sustain solid gains since the furlough scheme was terminated last September and in February payrolls were 662,000 or 2.3 percent above their pre-pandemic level in February 2020. Moreover, the gap would be wider but for staff shortages – vacancies are at record levels, underscoring the strength of demand for new workers. The redundancy rate is also at an all-time low.
In fact, notwithstanding a hit from Omicron in December and January, the economy has been running well ahead of market expectations since the BoE’s last meeting. Econoday’s economic consensus divergence indicator (ECDI) has been in positive surprise territory throughout and, after adjusting for inflation shocks (ECDI-P) even hit a record high in the second half of February. Real GDP growth in January was particularly robust. Nonetheless, sharply rising energy prices are set to knock consumer confidence, squeeze budgets and lead to a significant fall in real household disposable income over coming months. Discretionary spending will inevitably suffer and a slowdown in the growth of consumer demand will only be exacerbated by higher borrowing costs. To this end, it would seem sensible for the bank to move only cautiously.
Economic growth this quarter should receive a late helping hand from the steep decline in new Covid cases recorded since the end of January. During last month the infection rate fell almost as quickly as it rose when the Omicron wave hit in December and the government took the opportunity to lift all remaining restrictions on 24 February. While hardly draconian, their removal should still provide a useful boost to economic activity, particularly in services. That said, new cases have just started to rise again so there is no room for complacency.
In line with every other central bank mulling over the likely impact of the Ukraine crisis, the BoE will have to weigh up the conflicting implications for policy of rising inflation and slowing growth. Inflation is already far enough above target to suggest that not delivering another hike in Bank Rate on Thursday would be a hard act to sell but the potential damage to the real economy from the war at least argues in favour of nothing more than 25 basis points.