As expected, the Monetary Policy Committee (MPC) voted to hold rates at 3.75% in April as it waited to get a clearer view of the fallout from the conflict in Iran. The guidance took a slightly hawkish shift with one member voting to hike rates now compared to zero in March and the new forecasts suggested rate hikes might be needed to bring inflation back down to target unless energy prices quickly drop back.

Ultimately, this was another ‘wait and see’ meeting with the MPC pointing to the value in holding due to huge uncertainty around the outlook. The next move will depend on where energy prices go from here and whether there is evidence of second round effects. The risks of a rate hike have risen but it is far from guaranteed.

Everything is ‘“state dependent’”

The MPC was at pains to emphasise how difficult it is to take a view on monetary policy today. The words, risk, uncertainty and state-dependant appeared over 40 times in just the summary of the minutes.

Governor Bailey summed it up like this: "if the shock appears to be short-lived or the economy weaker, policy should place relatively more weight on avoiding unnecessary contraction in activity. If second-round effects are likely to be greater, policy should focus on returning inflation back to target more quickly."

Instead of presenting the traditional central forecast, the MPC chose to go with three scenarios. In scenario A oil and gas prices follow the futures paths and drop back sharply. Even in this case the Bank expects CPI inflation to rise to a little over 3.5% at the end of this year before falling to just 1.5% in Q2 2028, that would imply rate cuts would be needed rather than rate hikes. However, most of the MPC members dismissed this scenario as too optimistic.

In scenario B, in which energy prices remain higher for longer and some second-round inflation effects occur, inflation falls back to the 2% target at three-year horizon, suggesting rates may need to rise from 3.75% now to about 4.25%. That scenario is the one which most MPC members seemed to put the most weight on, so clearly raises the risk that most MPC members see the need to hike rates if energy prices remain high.

In scenario C, energy prices rise further, remain high and more significant second-round inflation effects require a “forceful tightening in monetary policy” to about 5.25%. That is hopefully an unlikely scenario, but clearly still plausible.

Putting this together – if energy prices stay around current levels or rise higher from here to mid-June when the next MPC meeting will be, the chances for a rate hike look pretty high.

Risk different from 2022 impact

If energy prices remain this high or higher through to the summer then rate hikes may be appropriate. However, there is a risk that the Bank is repeating the playbook from 2022 and is getting ready to fight the last war, even though the economy is in a very different place now than back then.

The key trade-off is the now familiar one between rising inflation pressures and weaker growth. But this isn't the same economy as in 2022 when demand built up in the pandemic was unleashed and the labour market was tight. Coming into this energy crisis demand was soft, the labour market was loose and financial conditions were tighter. That means the pass through from energy costs, to prices to wages is likely to be much more limited than in the Ukraine crisis.

Indeed, Governor Bailey made the point that firms have been saying that they have had difficulty in passing costs on. If companies are struggling to do this, then they will have to look at other ways to mitigate the surging input costs they face. Which, as the Bank of England hinted was a risk, could boost the unemployment rate. A rising unemployment rate would restrict employees ability to chase inflation busting pay rises.

Bringing it all together

The most important factor for the rates outlook remains the duration of the war in Iran and its impact on energy prices. If energy prices remain high, a rate hike in June looks like a good bet. However, if the economic data deteriorates between now and then, the emphasis from the MPC will shift from worrying about inflation to becoming more concerned about growth.

At the very least, we think any policy tightening cycle will be short and shallow and will be followed by rates cuts in 2027 once the inflation shock has peaked.

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