22 June 2022
A stubbornly tight labour market, soaring inflation and wandering inflation expectations mean the Monetary Policy Committee will probably opt for another 50bps hike at its next meeting on Thursday, 15 September. This will be despite its own forecasts that the economy will fall into a recession by the end of the year, and would take interest rates from 1.75% to 2.25%.
While the recently announced energy price freeze is a game changer for the economy, it may not have as a big an impact on the MPC’s decision making as it first appears. Admittedly, freezing energy prices:
- would significantly dampen headline inflation in the short term;
- would prevent some of the second-round effects the MPC is worried about; and
- will significantly lessen the coming recession.
This all points to a need for fewer interest rate rises in the short term. However, a large demand injection right when the MPC thinks the economy is overheating has the potential to stimulate the labour market and medium-term inflation. This is likely to lead to interest rates rising higher in the medium term.
A 50bps hike would take interest rates above our estimate of the neutral rate (1.75% to 2%), which is the rate that keeps the economy operating at potential with inflation at target. So, further hikes over the rest of this year would take interest rates into even more restrictive territory. We expect interest rates to peak at around 3.5% by the end of next year.
Recession won’t stop rate hikes
By raising interest rates by 50bps in July and forecasting a recession at the same time, the MPC sent a pretty clear message that if a recession is what it takes to get inflation under control, then it’s comfortable with that.
Since July, the economic outlooked has continued to worsen. Wholesale energy prices have kept surging, the PMIs have started flashing red and core inflation, which excludes volatile energy and food prices, has also started to rise again and reached 6.2% in July. Admittedly, the energy price cap has improved the economic outlook. But we’re still expecting the economy to slip into a mild recession this winter.
On the flip side, there is little sign of any easing in the labour market. The unemployment rate dropped to just 3.6% in July. But the number of people in employment is still about 200,000 fewer than before the pandemic. This has led to a surge in vacancies and upward pressure on wage growth. Crucially, Brexit and the lingering effects of the pandemic mean the labour force participation rate is unlikely to recover rapidly.
And with wage growth running at 5.5%, well above the rate consistent with the 2% inflation target of around 3%, the MPC is likely to conclude that more rate hikes are needed to take the heat out of the labour market. Indeed, businesses are expected to raise wages by 5.5% over the next year.
As a result, the labour market is likely to stay tight for the next few years, despite the weaker outlook for economic growth which, in turn, will keep nominal wage growth elevated. Higher wage growth risks higher inflation becoming embedded, which is what really worries the MPC. Medium term inflation expectations have also been creeping up. Inflation expectations in the Bank’s Decision maker panel survey, which it pays close attention to, have risen rapidly over the last few months. That suggests that businesses expect inflation to still be more than double the Bank’s 2% target in three years’ time.
So even though the MPC is likely to continue forecasting a recession (the MPC thinks the economy is likely to shrink by 2.2% from peak to trough, roughly the same as the 1990s recession), a tight labour market and rising inflation expectations mean that the MPC is likely to lean forcefully against inflation. We expect another 50bps hike.
Near-term inflation lower, but interest rates may end up higher
The new energy price cap means that inflation is probably already close to peaking. We now think inflation will rise from 10.1% in July to around 11% in October and November before falling back sharply over the next year.
By guaranteeing lower inflation for the foreseeable future, the cap could also reduce medium-term inflation expectations, which have been drifting in recent months. This suggests that the Bank of England will need to lead less heavily against inflation in the short-term.
However, that is unlikely to stop the Monetary Policy Committee (MPC) from raising interest rates next week.
Further ahead, a huge fiscal stimulus will also boost demand for domestic goods, services and labour. This is likely to keep inflation higher in the medium term and give support to core inflation, which excludes volatile energy and foods prices. Indeed, the Bank of England’s Chief Economist, Huw Pill, said that the Bank is there to ensure that fiscal policy “does not generate inflation”. So looser fiscal policy will probably just lead eventually to tighter monetary policy.
That suggests that interest rates will have to go higher in the longer term to get core inflation back to the MPC’s 2% target. We now expect interest rates to peak at 3.5% by the end of next year.