Monetary Policy Committee preview: MPC turns its hand to orology

19 September 2023

What do orology, the study of mountains, and economics have in common? Well, according to the MPC, the future profile of interest rates may resemble various mountain ranges. 

The MPC is debating the merits of two distinct types of mountains. In the ‘Matterhorn’ (the famous Toblerone mountain) approach, interest rates continue to rise steeply, this brings inflation under control quickly but can ignite a recession, then allowing the central bank to cut interest rates rapidly. Alternatively, the ‘Table Mountain’ (the flat-topped mountain in Cape town) approach suggests that interest rates don’t rise much further, but stay at their peak for longer. This creates a slower, more manageable drag on inflation and the economy. 

To us, the Table Mountain approach looks much more appealing. Afterall, there is a significant lag between a rise in interest rates and its impact on the economy. We estimate that around half of the surge in interest rates has so far come through to the real economy, so interest rates at current levels will have a significant dampening effect on inflation and the economy for a while yet. 

Since the last meeting, the data has moved in the direction the MPC wanted, suggesting that further steep interest rate rises are no longer warranted. Inflation is in line with its forecast, the unemployment rate has risen by more than it anticipated, and GDP growth looks to come in significantly below its Q3 GDP forecast. However, wage growth is far too high for the MPC to relax. 

This suggests the committee will opt for a 25bps hike next week, although the vote will almost certainly be split. The easing in the labour market and emerging weakness in the economy means this will probably be the last of the rate hikes. We then expect interest rates to remain at 5.5% until the second half of 2024, by which time inflation should have subsided enough to allow the MPC to start gradually cutting interest rates. 


Mixed data causes trouble in paradise 

The economic data we have had since the last MPC meeting in August has largely gone the committee’s way. Inflation fell to 6.8% in July, in line with the committee’s latest forecast. What’s more, the recent rise in the unemployment rate to 4.3% saw it reach the MPC's estimate of its equilibrium rate four quarters earlier than it expected. And after the 0.5% m/m drop in July, GDP looks set to rise by just 0.1% q/q in Q3, far below the MPC's 0.4% forecast. So far, so good. 

The problem is that wage growth has far exceeded the MPC’s expectation. Admittedly, the headline rate of pay growth of 8.5% was bumped higher by public sector bonuses. But private sector pay, excluding bonuses, was still 8% – miles ahead of the 3.5% the MPC thinks is consistent with its 2% inflation target. 


That mix of data is creating divisions within the MPC. And contrary to the usual tight-lipped nature of its members, there has been a flurry of comments recently. Bank of England Governor, Andrew Bailey, has said ‘interest rates are much nearer now to the top of the cycle.’ Meanwhile, Jon Cunliffe pointed to ‘mixed signals about the economy,’ which is ‘what you expect when you come into periods where you might be close to turning points.’ And Dhingra, the most dovish BOE rate-setter, said that policy is ‘already sufficiently restrictive’. Indeed, Bank Chief Economist, Huw Pill, suggested a ‘Table Mountain’ path for rates, where they stay high for longer. 

On the other side of the table, Catherin Mann said officials should ‘err on the side of tightening,’ to ward off more persistent inflation. 

It appears most of the MPC are signalling that peak interest rates are near. And though we think the strength of the wage data will still push the MPC into a 25bps hike next week, and that there will almost certainly be a split vote, probably 7-2 (25bps-unchanged) – there is a significant chance that more MPC members decide enough is enough and opt for a pause. Financial markets are pricing in a roughly 20% chance that interest rates have already peaked.

High for longer? 

Once terminal rate has been reached, whether it’s 5.5% or 5.75%, interest rates will have to stay there for a while. That’s partly because the aging demographic of the UK means around 35% of households now own their house outright, compared to around 25% in the early 1990s, and the proportion of households with a mortgage has dropped from around 40% to below 30%. As a result, a substantial portion of households are insulated from interest rate rises, which blunts their effectiveness at reducing demand. Rates will have to stay higher for longer to encourage this demographic to lock savings away rather than spending them. 

In addition, the changing structure of the UK mortgage market has lengthened the transmission lag. In the early 2000s, about 30% of mortgages were fixed, compared to above 90% now. While the interest rate on new mortgages has creeped over 6%, the effective rate, which is the average mortgage rate paid, is still below 3%. This means higher rates will eventually lower demand, it will just take longer – over two years – for hikes to impact the economy.

We aren’t anticipating rate cuts until late next year, by which time inflation should be low enough to allow the Bank to start gradually reducing rates. Even then, interest rates are only likely to come down gradually, too.