By Jeremy Hawkins, Senior European Economist
May 3, 2022
Despite some surprisingly dovish rhetoric from the BoE in March financial markets expect May’s MPC meeting to deliver a fourth successive increase in Bank Rate. If correct, the consensus call for a 25 basis point hike would see the benchmark rate raised to 1.0 percent, matching its highest level since early February 2009.
The March tightening was passed 8-1 with Deputy Governor Jon Cunliffe the sole dissenter calling for a steady hand. All the other 8 MPC members voted in favour of the 25 basis point increase to 0.75 percent. That move had no immediate implications for quantitative tightening (QT) but this week’s decision could be much more significant as 1.0 percent is the threshold for outright asset sales. Passive QT has already started via run-offs – the QE gilt stock shrinking around £28 billion to £847 billion in March as the bank stopped reinvesting maturing gilts. However, a 1.0 percent Bank Rate on Thursday would open the door to active QT whereby assets are sold before maturity to enable a more rapid decline in the balance sheet.
That said, note that 1.0 percent is just a potential threshold to begin sales, not necessarily an immediate trigger point. In fact, worries about liquidity may well mean that QT has to wait a while anyway – just last month Governor Andrew Bailey said that the bank would not sell into “fragile markets”. Still, the MPC could choose to flesh out its QT plans to help prepare market operators for the impending liquidity withdrawal. Either way, the bank has already indicated that the normalisation process will be only gradual so QT is likely to be around for some time. Just what size the BoE sees as the future ‘normal’ for the balance sheet is unclear but it will be significantly smaller (most probably less than half) of its current near-£1 trillion level. In February the IMF suggested that QT should be around £650 billion.
The start of active QT should help to reduce the burden of policy tightening on interest rates. Nonetheless, financial markets are still expecting aggressive BoE rate hikes and see SONIA (Sterling Overnight Index Average) climbing above 2 percent before year-end. This could be achieved by a sustained sequence of 25 basis point increases at each MPC meeting in the interim but a larger 50 basis point hike at some point would accelerate the process should the MPC so desire. However, with the four MPC members who wanted the larger rise in February apparently happy with March’s 25 basis points, it is not clear that there is now much appetite for anything more than small, incremental changes. Looking further ahead, how far up rates will go is very uncertain. Back in 2018 under previous Governor Mark Carney, the Bank signalled that it saw the real equilibrium level of Bank Rate at around 0.5 percent. Adding in the inflation target (2 percent) would put the nominal rate at about 2.5 percent but the Bank no longer commits to a precise level.
In any event, with inflation continuing to surprise on the upside and some other central banks having already adopted a more aggressive approach to tightening, there remains plenty of pressure on the MPC to act. Key is inflation where the annual headline rate soared well above expectations to fully 7.0 percent in March, its highest post since March 1992. This matched the peak level that the BoE forecast in its November Monetary Policy Report (MPR) before that was revised up to 8 percent in the February edition. However, with the energy regulator, Ofgem, having raised the cap on domestic fuel bills by more than 50 percent at the start of April, even the predicted 8 percent is likely to be too low. The new MPR (also released on Thursday) will very probably contain a stronger prediction, adding to pressure for another hike in rates.
Businesses are certainly pessimistic on the outlook for prices. The BoE’s April survey of its Decision Maker Panel (DMP) found nearly 3,000 UK chief financial officers on average expecting to raise prices by 5.9 percent in the coming year, easily the largest forecast increase since the survey began five years ago. Significantly, companies apparently anticipate few problems passing rapid cost increases onto customers. In the same vein, the April Citi/YouGov survey put households’ year-ahead expectations at some 6.0 percent, just a tick short of March’s record high. The bank pays a lot of attention to a range of measures of inflation expectations and the latest data can only add to worries that the actual rate may remain above 2 percent for longer than currently assumed.
A major issue for policymakers is the increasing imbalance between the demand for, and supply of, labour. Demand is expanding rapidly and employment is at an all-time high. However, supply continues to be restricted by a combination of fewer EU workers, Covid and the fallout from the war in Ukraine. As a result, vacancies are at record levels and still climbing sharply which, together with the declining availability of workers, has put considerable pressure on the labour market. Indeed, the ratio of unemployed people per vacancy has declined dramatically and hit a record low of 1.0 in the three months to February 2022. Against this backdrop, recruitment consultancies are reporting record increases in starting salaries for permanent staff as well as higher pay for temporary workers.
On the other hand, while the real economy looks to have had a decent first quarter – helped in no small way by the lifting of all remaining Covid restrictions – growth is slowing. In fact, most of last quarter’s rise in real GDP will be attributable to January which saw a 0.8 percent monthly spurt; February was up just 0.1 percent. Real household disposable incomes are being squeezed by a combination of rising inflation, increased taxes and higher borrowing costs. Retail sales volumes fell in March for a third time in the last four months and the CBI’s latest distributive trades survey warned of a poor April too. At the same time, the flash April PMI found the smallest increase in business activity since January with supply chains being seriously disrupted by Covid, notably China’s zero Covid policy, and the war in Ukraine. The CBI’s quarterly business optimism index also saw its steepest fall since just after the arrival of the virus.
To make matters worse, international trade continues to struggle due to Brexit effects. According to the government’s main forecasting body, the Office for Budgetary Responsibility (OBR), trade as a share of UK gross domestic product has fallen 12 percent since 2019, about 2.5 times more than in any other G7 country. The IMF now expects the UK to have the slowest growth of all the major advanced economies in 2023.
To be sure, the early signs are that the fallout from the Ukraine crisis has had a larger impact on economic activity than markets anticipated. Having been largely in positive surprise territory over the year to date, in late April Econoday’s economic consensus divergence indicator (ECDI) slipped below zero. More strikingly, after adjusting for inflation shocks (ECDI-P), the index slumped to a record low. This has prompted speculation about negative GDP growth this quarter which, if realised, would make additional interest rate hikes – especially large ones – politically all the harder to sell.
BA.2, a sub-variant of the highly transmissible Omicron version of coronavirus, is now dominant in the UK (and the world), accounting for more than 94 percent of all cases in England. However, while even more transmissible than Omicron, harder to track and more resistant to vaccines, it is not thought to be any more likely to cause serious disease. As it is, new infections in the UK have declined steeply since their peak in late March after the remaining restrictions were lifted in February and the economic impact of the virus, while still a real risk, appears to be diminishing. That said, self-isolation remains an issue that is impacting labour supply and so adding to tightness in the labour market.
As above target inflation has continued to accelerate right around the globe, financial markets have become increasingly hawkish in their view of where interest rates are headed. However, while some central banks have already raised benchmark rates by more than 25 basis points at a single meeting – and the Fed seems certain to follow suit on Wednesday – the BoE looks likely to favour caution. A 50 basis point move is certainly possible on Thursday but, as Governor Bailey recently pointed out, the bank needs to walk the fine line between combatting inflation and avoiding recession. Monetary overkill now could be just as damaging as tightening too little.