MPC meeting: Terminal rate of 3.5% likely, but don’t rule out 4%

A super tight labour market, soaring inflation and a massive fiscal stimulus mean that today’s 50 basis points (bps) hike in interest rates probably won’t be the last large rise. We expect interest rates to peak at 3.5% early next year, but a peak of 4% is also possible.

In a three-way split decision, the Monetary Policy Committee voted to raise the benchmark rate to 2.25% from 1.75%, despite the MPC saying it thinks the economy is already in recession. One member voted for a 25-bps increase, while three called for a 75bps hike and the majority of the committee went for a 50bps rise. Only one member voted for a 75bps hike at the last meeting, so this suggests the committee is becoming more hawkish.

Middle market businesses should brace for an extended period of shrinking and weak demand, rapidly rising energy costs and higher interest rates.

Higher rates to offset higher fiscal spending

The new energy price cap means that inflation is probably already close to peaking. We now think inflation will rise from 9.9% in August to around 11% in October before falling back sharply over the next year.

By guaranteeing lower inflation for the foreseeable future, the cap could also reduce medium-term inflation expectations, which have been drifting in recent months. This suggests that the Bank of England will need to lead less heavily against inflation in the short-term.

However, further ahead, a huge fiscal stimulus will also boost demand for domestic goods, services and labour. Indeed, while the Bank said that the Energy Price Guarantee, “will lower and bring forward the expected peak of CPI inflation,” it also said it means that, “household spending is likely to be less weak than projected…[and] all else [being] equal…this would add to inflationary pressures in the medium term.”

How far will interest rates rise?

The MPC left the door ajar for further 50bps rate hikes by saying, “The scale, pace and timing of any further changes in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. Should the outlook suggest more persistent inflationary pressures, including from stronger demand, the Committee will respond forcefully, as necessary.”

The mention of ‘demand’ in the guidance is a new addition, and suggests the focus will be on the impact of fiscal loosening expected from the government.

With demand likely to be stronger as a result of the package, inflation should be higher further ahead. In fact, it may be that the MPC keeps up the pace of tightening in the coming months.

The ultimate determinant of how high interest rates go will probably be the labour market. The MPC is unlikely to pause its tightening cycle until there is evidence that wage growth (currently at 5.5% y/y) is starting to come down to closer to the 3% y/y that the MPC thinks is consistent with its 2% inflation target. That will require the unemployment rate to rise significantly from its current 48-year low of 3.6%.

We expect a 50-bps hike in November and 25-bps increases in December, February and March. That would mean rates peaking at 3.5% in the first quarter of 2023.

Quantitative tightening despite more borrowing

The MPC decided to commence active gilt sales despite the large increase in government borrowing that will accompany the government’s energy support package. That likely reflects the MPC’s desire to avoid accusations that its balance sheet decisions are linked to the outlook for gilt issuance. Remember, the MPC has already stopped reinvesting the proceeds from maturing assets, so these active gilt sales will be in addition to that. As a result, the Bank’s balance sheet will shrink by about £80bn over the next year or so.

This will act as another dampener on the economy but, given financial markets are relatively calm, we don’t think quantitative tightening will be a big contributing factor.