MPC Meeting: Ofgem to gift UK a recession for Christmas

22 June 2022

The Monetary Policy Committee (MPC) still desires to bring about price stability, and so has raised interest rates from 0.75% to 1%. This marks the first time the MPC has raised rates at four consecutive meetings, and rates are now at their highest level since the financial crisis.

The vote at Thursday’s meeting was unanimous for the 0.25% rise. However, the minutes made it clear that the committee is very split. Three members wanted to go further and raise rates by 0.5%, but two members did not want to include guidance that more rate hikes were needed – saying, in effect, that they think no more rate hikes are needed.

Uncertainty therefore reigns, but we suspect financial markets are being overly ambitious in expecting interest rates to reach 2% by the end of this year. That’s because at least some MPC members do not see a need for more rate hikes, and the economy will effectively stagnate over the next two years.

Downside growth risks, upside inflation risks

The key message the MPC was trying to get across with its forecasts today was that inflation is likely to rise sharply over the next year but the economy will essentially stagnate.

The MPC upped its inflation forecast from a peak of 7.25% in April to 10.25% in Q4, as Ofgem will probably have to significantly revise its energy price cap up by another 40% in October.

The MPC also revised down its economic forecasts, saying that although the economy will avoid a technical recession it now expects GDP growth of -0.25% in 2023 and +0.25% in 2024. The Bank is not forecasting a recession, but it expects GDP to contract by 0.9% q/q in Q4 2022 and by 0.2% q/q in Q3 2023. And it revised down its 2022 forecast for household real income growth from -2.0% to -3.25%.

The tight labour market means that the Bank expects pay growth to rise to 5.75% in 2022 – sharply higher than the February outlook – before falling over the next two years.

Higher inflation now, lower inflation ahead

As we expected, the MPC’s forecasts, which are based on the way the market indicates that interest rates are going, showed inflation to be well below target in three years’ time. The forward curve used in the forecast envisions rates peaking slightly at 2.5% in the middle of next year. That was far higher than the rate path used in the MPC’s February projection, which had rates peaking at just under 1.5% in 2023.

Based on this market indication for interest rate three years ahead, the MPC thinks inflation would be just 1.3% in three years’ time. That’s larger than the one projected in February (1.6%), and strongly suggests that the MPC sees the scale of tightening assumed by financial markets as too aggressive.

However, the MPC also produces a forecast that assumes policy remains unchanged. This forecast showed a modest overshoot of inflation three years ahead, with annual CPI at 2.2%. The takeaway message from this is that, while interest rates may have to rise a little more to bring inflation down, the MPC thinks that a rate of 2.5% would be far too high.

How far will interest rates rise?

Given the split on the MPC, it’s clear that the committee doesn’t have a good idea itself of where interest rates will go over the rest of this year. But the message from the MPC was decidedly dovish.

Indeed, the policy statement said that ‘some degree’ of further tightening in policy may be appropriate compared to ‘modest tightening; previously. What’s more, while the MPC said it will now ‘consider’ whether to shrink its balance sheet quicker by selling gilts, it said it won’t make an actual decision until after the meeting in August.

All this suggests that interest rates will probably rise a little further over the rest of this year. We will be watching the jobs market particularly closely, which is likely to hold up in the near term, only softening in the second half of the year. But there’s a risk that the near-term strength concerns the MPC enough for it to respond by lifting rates further in the summer, potentially in June or August.

The jump in interest rates to 2.5% implied by markets seems less likely now. However, until the pervasive uncertainty surrounding the current domestic and global economic outlook abates, it is almost impossible to have a sensible idea of where interest rates will end up.