Monetary Policy Committee preview: Terminal rate of 5%

16 June 2023

Soaring wage growth and sticky inflation mean another 25bps rate hike at the Monetary Policy Committee’s (MPC) next meeting on 22 June, which will take rates to 4.75%, now seems a sure bet. The bigger question is how many more rate hikes will follow.

There can be no doubt that the economy has turned out to be more resilient than the Bank of England was expecting, which has caused a tighter labour market and stickier inflation. This probably justifies taking interest rates to 5% over the summer. However, by the end of the summer, we think inflation will have fallen far enough, and enough slack will have been created in the labour market to allow the MPC to conduct a hawkish pause.

The case for hiking in June and August is solid…

The economic data we have had since the last MPC meeting in May has turned out to be largely stronger than the committee expected. Headline inflation was 0.3ppt higher in April than the bank expected. What’s more, core inflation increased to 6.8% from 6.2% and services inflation jumped to 6.9% from 6.6% –both well above the MPC’s forecast.

As if that wasn’t enough, the employment data for April portrayed a still red-hot market. Average weekly wages in the private sector, excluding bonuses, increased to 7.9%, from 7.4% in March, suggesting that the MPC’s forecast for growth of 6.3% in Q2 is too low.

Even the meagre 0.2% m/m GDP growth in April suggests that the economy is still resilient, especially when we look past the impact of strikes in the public sector, which have dragged down overall GDP.

All this depicts an economy where spending is strong enough for firms to feel they can comfortably pass on cost increases and the labour market is tight enough that employees can demand, and receive, high increases in wages.

The only way to resolve this is for the MPC to raise interest rates high enough to start sucking demand out of the economy. If the outlook for employment looks more precarious, then workers will be less inclined to push for a pay rise and demand is likely to soften. As a result, firms will be less willing to raise prices for fear of losing market share.

All the recent data suggests that interest rates will have to go higher to reach this point. Indeed, given that the MPC’s guidance in May was that if the economy turns out to be stronger than its forecasts then more interest rate rises would be necessary, we think a rate hike next week is guaranteed and another in August is highly likely. This would take interest rates to 5%.

…further rate hikes are less certain

After that, the case for further rate hikes becomes a bit less convincing.

Inflation has proved a bit stickier than the bank forecasted, but it will still fall sharply over the rest of this year. Fuel, energy and food prices on international markets have all fallen dropped significantly and this will feed through into much lower inflation and, in some cases, deflation later in 2023 and into 2024. That will mean that inflation should fall from 8.7% in April to about 4% by the end of the year.

What’s more, the labour market will start to ease. On the demand side, the number of vacancies has dropped by more than 200,000 since this time last year and redundancy notifications so far in 2023 are about 50% above the same period last year.

On the supply side, the workforce is starting to recover. The number of inactive people (those who are not working and are not looking for a job) has fallen by about 250,000 since its peak in Q2 last year. Immigration has also remained strong, despite Brexit making it more difficult to recruit overseas low-skilled workers.

This will start to bear down on wage growth and services inflation.

There is also the lagged effect of previous rate hikes on the economy to consider. We estimate that around half of the 415bps increase in the base rate has been passed through to lending rates that businesses and consumers face. As a result, the flow of new credit has eased substantially, so that new credit is no longer adding to growth. The recent rise in interest rates to 4.5% and the potential further rise over the summer would mean that credit conditions may deteriorate further over the next few months.

Tighter credit conditions make it more expensive for firms and households to borrow to invest and spend, weighing on economic activity. We estimate that the increase in mortgage rates so far this year will knock another 1ppts off households’ gross disposable incomes this year. Indeed, the impact of higher rates is already being keenly felt in the construction sector, which contracted by 0.6% m/m in April. At some point it will be sensible for the MPC to wait to see the full impact of the previous rate hikes before continuing to hike. We think that level is around 5%.

Conclusion

Another two interest rate hikes seem likely, which would take interest rates to 5%. It would therefore seem sensible for the MPC to take a hawkish pause in much the same way that the Fed did yesterday. This would allow the MPC to examine the impact of its previous rate hikes, while giving it the option to hike further if needed.

As it happens, we think by September it will become clear that inflation is on a steep downward track and that enough slack has emerged in the labour market for the MPC to stop its tightening cycle at 5%. However, the risks are definitely weighted toward intertest rates going higher. Financial markets are probably over-egging the chances of a 6% terminal rate, but don’t rule it out.

  • Geopolitics and inflation risk
  • Slowing wage growth and BoE
  • Inflation on its way to 2%
  • Retail recovery underway

Geopolitics and inflation risk

Not slowing fast enough for MPC

The Bank of England (BoE) has signalled it’s nearing the end of its hiking cycle. But another batch of jobs data that shows the labour market is still tight and sticky wage pressure will likely keep the committee from pausing just yet.

We see the unemployment rate averaging 3.7% in the last quarter of the year – unchanged from the three months to November, and only slightly up from 3.6% in Q3 22. That’s in line with the Bank’s forecast. Even though vacancies are falling, a more sustained drop is needed for a meaningful spike in redundancies, as job openings are still well above their ‘normal’ levels.

Wage pressures probably remained strong. We forecast regular private sector pay growth at 7.2% in the last quarter of the year, unchanged from the three months to November. For the whole economy, wage gains are likely to have increased slightly, to 6.6% from 6.4% previously, reflecting a boost in annual public sector pay growth over that period.

On the back of falling inflation and a looser labour market, we think private pay growth has peaked and will start to slowly ease over coming months. We expect private wage gains to halve by the end of the year. But that probably won’t come fast enough to stop the Monetary Policy Committee from raising interest rates by another 25bps at its next meeting in March. 

Slowing wage growth and BoE

Low confidence holding back sales

Consumer spending is set to remain under pressure, given the biggest income squeeze in a generation. Public transport strikes in January are also likely to have hampered sales as well.

Still, the hit may have been softened by an easing in energy prices as well as a growing take up of ‘buy-now-pay-later’ products.

At the same time, the prospect of higher mortgage rates may also be leading to more households to adjust their consumption in the new year.

UK consumer confidence remains near record lows, even below levels seen during the global financial crisis, the pandemic lockdowns and recessions in the 1980s and 1990s.

All in, retail sales volumes probably fell again in January, although at a slower rate than they did in December. 

Inflation on its way to 2%

Headline rate falling but core still sticky

Headline Consumer Price Index (CPI) inflation likely fell again in January to 10.3% from 10.5%. Our view is less optimistic than the BoE, which sees inflation dropping to 10.1%.

Much of the fall in the headline rate is likely to be explained by fuel prices, which fell by nearly 4% in January. The uncertainty around our forecast is larger than usual due to the annual reweighting of the CPI basket.

As it weighs the case for hiking again, the BoE has made clear that it is watching for signs of persistence in the inflation data. In particular, it will be keeping a close eye on services inflation. We expect the gauge to rise again in January to 7.1% from 6.8% as businesses continue to pass on higher energy and labour costs.

Core services inflation (which excludes education, airfares and package holidays) is likely to come in a little hotter than the central bank expects. Core goods inflation, meanwhile, is likely to fall back, meaning annual core CPI remains at 6.3%.

Headline CPI Inflation will likely edge down over 2023, mostly due to favourable base effects. We see it averaging 9.9% in Q1 23, before ending the year at 3%.

Retail recovery underway