29 July 2022
The Monetary Policy Committee seems set to give us the biggest rise in interest rates since 1995. It looks like the latest data showing a robust labour market and soaring inflation will be enough for the MPC to make good on its promise to ‘act forcefully’ in response to more persistent inflation.
As a result, expect a 50 basis point (bps) rise in interest rates, from 1.25% to 1.75%. (For context, that’s the biggest increase since the invention of the DVD.) The vote is unlikely to be unanimous – it will probably be 7-2 – and it should be more finely balanced than the 90% priced into financial markets. What’s more, there are clear signs of weaker global and domestic economic growth, pointing to a slower pace of tightening after August.
A 50bps hike would bring interest rates roughly into line with our estimate of the neutral rate, 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 restrictive territory. We expect interest rates to peak at around 2.75% in the first half of 2023. At that point, the MPC is likely to pause as the soft demand outlook deals a more material hit to hiring, labour supply recovers somewhat, and the outlook for inflation becomes more benign.
Inflation is rising, but so are recession risks
The MPC will update the economic forecasts it made in May. Back then, it thought inflation would peak at just above 10% in Q4. However, the sharp reduction in natural gas flows from Russia to Europe since have sent UK natural gas and electricity prices soaring to their highest levels since March. We now think that Ofgem will increase the energy price cap in October by at least another 50%. That would mean that inflation will peak at close to 12%.
Admittedly, there are some encouraging signs on the inflation front. Core inflation, which excludes energy and food, has fallen recently and will probably continue to drift down this year as last year’s surge in goods prices drops out of the annual comparison. What’s more, grain prices have returned to their pre-war levels and oil prices have fallen by about 10% from their recent highs. All of this will help to bring down inflation eventually. But inflation in the services sector, which tends to be more persistent than price gains for goods, has picked up sharply. In addition, the central bank’s Decision Maker Panel survey suggests inflation expectations have risen further in recent months.
The MPC will have to offset soaring inflation against the growing risk of a recession. Economic conditions have continued to deteriorate since the May forecasts were made. In June, the Bank revised down its second quarter GDP forecast, from +0.1% q/q to -0.3% q/q, which, admittedly, seems a little too pessimistic now. But the Bank will probably slightly revise down growth this year and next. Indeed, surging inflation will cause real household disposable incomes to fall by more than 3% this year, the largest on record, and that will cause GDP growth to flatline later this year – and possibly contract. Bank of England governor, Andrew Bailey recently commented that, ‘The global outlook has deteriorated markedly.’
And while we do not expect the MPC to signal that the UK will fall into recession, it will presumably highlight this as a significant risk. In fact, according to the Bloomberg consensus of economic forecasts, the chances of a recession within the next 12 months have risen from 15% in March to 45% currently.
MPC most worried about tight labour market
In normal circumstances, the MPC wouldn’t be too concerned about the energy price shock and the deterioration in the UK’s terms of trade (because the price of the UK’s imports has risen by more than its exports) pushing up the headline rate of inflation. That’s 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 with the economy adding almost 300,000 jobs in the three months to May. 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.
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. Inflation expectations in the short-term, at least, have actually risen rapidly and may require higher interest rates to bring them back down.
Echoing these concerns, the Bank’s Chief Economist, Huw Pill, said, ‘Given the tightness of the UK labour market and perceived strength of pricing power in large parts of the corporate sector, the threat exists that higher headline inflation leads to second round effects in prices, wages and costs that exacerbate the magnitude and, crucially, the persistence of the target overshoot.’
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 their 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 May, with financial markets now expecting interest rates to reach 2.75% 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 May, financial markets saw rates reaching around 1.75% by mid-2023. Based on that assumption, the MPC saw unemployment rising to 5% and inflation falling to 1.5% 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 90% chance of a 0.5% rate hike. We agree that 0.5% is the most likely outcome, but two members are likely to vote for a 0.25bps hike and we think the decision is more finely balanced than what’s implied by the 90% priced into markets. And remember, the MPC dramatically wrongfooted the market in November, December and February.
The MPC is likely to maintain its current guidance, keeping the flexibility to make larger moves at subsequent meetings. That poses an upside risk to our forecast, which sees the committee reverting to steps of 25bps as the domestic and global economy show further signs of strain in the winter.
In May, the MPC said it would provide an update on its strategy for active gilt sales at the August meeting. Governor Andrew Bailey has said the pace of balance sheet run-off (including redemptions) will be between £50bn and £100bn in the first year. Gilt sales are another form of monetary tightening, so the faster the BoE sells gilts the more financial conditions will tighten – which will also slow economic growth.