22 June 2022
Monetary Policy Committee preview: To go big, or really big?
A stubbornly tight labour market, soaring inflation and a significant increase in interest rate expectations mean the Monetary Policy Committee will almost certainly go big at its next meeting on Thursday, 3 November. The only question is, how big?
The need for a huge rate jump of a full percent or more has receded, now that almost all of the risk premium on UK assets associated with the “mini-Budget” has disappeared and most of its tax cuts reversed. As a result, we expect the MPC to raise rates by 75bps to 3% – so the MPC might go big, but not really big.
The delay of the medium-term fiscal plan to November doesn’t change this view. Sunak has a credible reputation with markets and that he has delayed the fiscal plan without triggering big market moves is a case in point. Importantly, the MPC will be working with the assumption that material fiscal consolidation is coming -- even if it can’t officially include it in the November forecast. As such, the tone of the minutes may lean against market expectations that rates will peak at over 5%. Overall, we’re expecting interest rates to peak at 4.5% early next year.
Don’t rely on this round of economic forecasts
The MPC will update the economic projections it made in August. However, it will follow the convention of forecasting on the basis of confirmed government policies. This means the MPC is unlikely to factor in either the early ending of the energy price guarantee or the fiscal consolidation that’s expected to be part of the Autumn Statement on 17 November. It’s anticipated that the Chancellor will announce a fiscal contraction of between £30bn to £40bn (1.1% to 1.5% of GDP).
As a result, it’s safe to say that the set of forecasts announced on Thursday will show the economy and underlying inflation as being a little stronger than the MPC actually believes. In addition, there is a huge question mark over if and how the government will reform the energy price guarantee – and that will make a big difference to inflation over the next year. Inflation in April 2023 could be anywhere between 5% and 11%, depending on what happens to the energy price guarantee.
But none of this seems enough to stop the MPC from raising rates sharply in November. Core inflation, which excludes volatile food and energy prices, hit 6.5% in September, its highest level since 1992.
On top of that, the labour market has continued to tighten. The unemployment rate dropped to just 3.5% in August, but the number of people in employment is still about 300,000 fewer than before the pandemic. This has created a surge in vacancies and upward pressure on wage growth. Crucially, Brexit and the lingering effects of the pandemic mean that the labour force participation rate isn’t set for a quick recovery.
And with wage growth running at 6%, well above the rate consistent with the 2% inflation target of around 3%, the MPC could 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.
The upshot is that the labour market looks like it will stay tight for the next few years – despite the weaker outlook for economic growth that, 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 (in August, the MPC thought the economy would 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 ought to lean forcefully against inflation by raising interest rates by 75bps to 3% in September. This will probably be followed by a 50bps hike in December, February and March.
The big picture is that the MPC is unlikely to stop raising rates until it sees convincing evidence that the labour market is loosening, and wage growth is coming down.
Financial markets overestimating how high interest rates will have to go
However, we do think financial markets have gone too far in expecting interest rates to peak at almost 5.5% next year. In a recent speech, Ben Broadbent, Deputy Governor of the Bank, pointed out that, “If Bank Rate really were to reach [just over 5%], given reasonable policy multipliers, the cumulative impact on GDP of the entire hiking cycle would be just under 5% – of which only around one quarter has already come through.” That would be a massive hit to the economy and would suggest a much deeper recession than is needed to get inflation back down to the 2% target.
And when we factor in the period of austerity that the government seems ready to impose over the next few years, the case for interest rates above 5% looks even weaker. Indeed, Broadbent finished his speech with the line, “Whether official interest rates have to rise by quite as much as currently priced in financial markets remains to be seen.”
That’s about as close to an MPC member saying “markets have gone too far” as you’re likely to see. We expect interest rates to peak at 4.5%.