16 June 2022
Interest rates are now at their highest level since the global financial crisis of 2008. The Bank of England has lifted interest rates by 25 basis points (bps), marking the fifth consecutive hike and taking interest rates to 1.25%. We still expect another three hikes of 25bp this year, which would send interest rates to 2%.
However, by pledging to ‘act forcefully’ in response to indications of more persistent inflation, the MPC has hinted that it is open to larger interest rate rises in future. As such, there is a strong possibility of a 50bps move in August.
Lower growth, higher inflation
The 6-3 vote in favour of a 25bps hike (the other members of the committee wanted a 50bps rise) illustrates the fundamental challenge facing the MPC – how to reconcile a weak economy with soaring inflation.
Indeed, the committee raised its inflation forecast for the fourth quarter from ‘slightly over 10%’ in May to ‘above 11% in October’. At the same time, the Bank revised down its second quarter GDP forecast, from +0.1% q/q to -0.3% q/q.
Some members of the committee think a tight labour market will persist for longer, and so they favour front-loading rate hikes to bring inflation under control more quickly, but that runs the risk of tipping the economy into recession. The majority, however, thinks the economic outlook is already weak enough that gradual interest rate rises over the course of the next year will be enough to bring inflation under control.
In fact, the MPC reiterated its forecast from May that CPI inflation was projected to be some way below the 2% target in three years’ time. It said that ‘demand might be starting to slow in line with the May forecast’.
More hawkish guidance
Nevertheless, the committee as a whole took a hawkish turn, saying ‘The scale, pace and timing of any further increases in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response.’
This is the MPC flagging that it is open to bigger or faster rises in interest rates if inflation turns out to be worse than it expects. This is a big shift from May, when two members declined to even sign up to guidance that more hikes were needed. What’s more, the mention of ‘scale’ and ‘forceful’ both imply 50-bps moves are now on the table for all policy makers.
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 today was decidedly more hawkish than it was in May.
This suggests that interest rates have considerably further to go over the next year. We currently anticipate a further three rate rises of 25bps this year, which would take interest rates to 2%. That said, there is still a good chance the MPC opts for one or even two 50bps rises in August and September, which would take interest rates to 2.5%. At the moment, financial markets expect rates to peak at 3.5% by this time next year.
Even so, we continue to think there will be a pause in the first half of next year as the soft demand outlook hits hiring, labour supply recovers somewhat, and the outlook for inflation moves on to a downward trajectory.
The majority of the MPC appears to be hoping to that the weak economy will do most of the work required to reduce inflation to the 2% target. This is certainly what the Bank’s forecast of inflation dropping well below target in 2024 seems to suggest.
The big risk is that the MPC is putting too much weight on the chances of damaging the economy, and too little weight on controlling inflation. This would mean that the Bank would have to raise interest by even more later on to bring inflation and expectations back to target. This does seem to be the scenario that financial markets have priced in. We think a peak of 3.5% is unlikely, but don’t rule it out!