22 June 2022
At the Monetary Policy Committee’s (MPC) next meeting on 5 May, we’re expecting a unanimous vote to raise interest rates from 0.75% to 1.00% and for the committee to announce that it will start selling bonds. But given how uncertain the outlook is for the economy and inflation right now, no hike and a 0.5% rise are also significant possibilities. Ultimately, the degree of monetary tightening over the rest of this year will depend on whether the MPC is convinced that a tight labour market and rising inflation expectations will lead to persistently higher inflation.
Walking a very, very fine line
Bank of England governor, Andrew Bailey, summed up the difficulties facing the MPC last week. He pointed out that it is walking a very, very fine line between failing to tackle inflation and the risk that the cost-of-living crisis and rising interest rates creates a recession. This would push medium term inflation well below its 2% target.
These opposing aims will probably be clear when the Bank updates the economic forecasts it made in March.
Since then, the economic conditions have deteriorated. The Russian invasion of Ukraine caused a surge in the prices of all major commodities from oil to wheat, which has dramatically pushed up the inflation profile. Indeed, the committee flagged in the minutes of its March meeting that it expected inflation to overshoot its February forecast by about a percentage point in Q2, moving close to 8%. Given inflation has surprised to the upside since that meeting, it is likely to suggest that inflation will rise to about 9% in April.
What’s more, inflation is now likely to stay higher for longer. Ofgem’s energy price cap is likely to rise by another 40% in October, compared to the 15% the Bank expected in February. And wholesale prices suggest food price inflation will continue to rise to around 7%. Producer input price inflation of 19.2% in March also implies that goods prices will continue to rise over the rest of the year. All in, the Bank is likely to suggest that inflation will average 9% for the rest of this year.
At the same time, this surge in inflation will cause real household disposable incomes to fall by more than 2%, the largest on record, which will cause GDP growth to flatline later this year. And while we do not expect the MPC to signal that the UK will fall into recession, it will probably highlight this as a significant risk.
Elsewhere, the labour market has continued to tighten. The unemployment rate fell to 4.1% in November, only slightly higher than its pre-crisis level. Pay growth is also a little stronger than the MPC previously envisaged. The committee will probably revise down its unemployment rate forecast from 4% to 3.75%, heightening concerns that wage growth will feed through into higher medium-term inflation.
MPC worried about tight labour market
While the energy price shock and the deterioration in the UK’s terms of trade (because the price of the UKs imports has risen by more than its exports) have pushed up the headline rate of inflation, the MPC would not normally be too concerned because these types of events tend to push up the price level, but don’t have a lasting effect on the rate of inflation.
Instead, it’s the tight labour market that is really worrying the MPC. Demand for labour has held up strongly, but the number of people in employment is still about 600,000, or 2%, 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.
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. Indeed, inflation expectations in the short-term at least have risen rapidly and may require higher interest rates to bring them back down. Indeed, Governor Bailey has said that “the combination of supply shocks and a tight labour market tends to give us more of a problem of persistent inflation.
Lower medium term inflation
Surging inflation and a tight labour market would usually be a slam dunk combination for interest rate rises. But there are two things that might prevent the MPC from raising rates rapidly over the next year. First, surging energy prices have done some of its job by taking the heat out of the rest of the economy. Put simply, if consumers are spending more of their incomes on imported energy and food, then they have less to spend in the domestic economy. This lowers demand and feeds through into lower domestically generated inflation in the medium term.
Second, interest rate expectations have jumped since February, with financial markets now expecting interest rates to reach 2.5% by early 2023. As many financial products, such as mortgages and loans, are partly priced based on rate expectations this will already be sucking demand out of the economy.
In February, financial markets saw rates reaching a little under 1.5% by mid-2023. Based on that assumption, the MPC saw unemployment rising to 5% and inflation falling to 1.6% at the three year horizon. Now that rate expectations are 1ppt higher, it is likely to forecast even higher unemployment and lower inflation in the medium term.
So, the MPC will have to make a trade-off between raising rates, to quell rising inflation and dampen pay growth in a tight labour market, and tipping the economy into recession and undershooting its inflation target in a couple of years’ time.
The immediate decision
Financial markets are pricing in a 100% chance of a 0.25% rate hike, and a small chance of a 0.5% rise. We agree that 0.25% is the most likely outcome, and there is a chance that some members of the committee vote for a 0.5% rise given the recent increase in inflation expectations. But, remember, the MPC dramatically wrongfooted the market in November, December and in February. Indeed, there is a real chance of no rate rises or a 0.5% rise this week.
If the MPC does raise rates then it will have reached the 1% threshold it previously said it needed to consider selling its bond portfolio. The MPC will probably announce that it has decided to sell bonds, but say it has asked Bank staff to look into the best way of doing it. This is what it did in February when it decided to sell its corporate bonds.
However, given how uncertain the economic outlook is at the minute we suspect the MPC will want to conserve as much flexibility as possible. This could limit the amount of forward guidance it gives.