At the Monetary Policy Committee’s next meeting on 17 March, we’re expecting a unanimous vote to raise interest rates from 0.50% to 0.75%. But given how uncertain the outlook for the economy and inflation is currently, we expect the MPC to signal that its next moves will be entirely dependent on the incoming data.
Stuck between a very big rock and a very hard place
The MPC will have to weigh up surging inflation against the inevitable hit to economic growth from rising commodity prices.
It’s clear that increases in the price of energy products and a swathe of commodities, from wheat to aluminium, will send inflation sharply higher in the next few months and keep it high for the rest of the year. We expect inflation to rise from 5.5% in January to peak at around 8.2% in April, when the 54% rise in Ofgem’s utility price cap comes into effect and the surge in oil prices feeds through into higher petrol costs.
It will remain high over the rest of the year as the increase in commodity prices will prevent it dropping by much (commodity prices take longer to feed through into inflation than oil prices). What’s more, rather than falling by about 5% in October as we expected it to, Ofgem’s price cap may rise again by another 30%, raising the chance of a second inflation peak in October.
All this means inflation will probably be above 5% at the end of 2022, and it may not be until the end of 2023 that inflation is back at the 2.0% target.
At the same time, surging energy prices, plummeting consumer and business confidence and renewed supply chain disruptions will cause GDP growth to slow significantly. We have already reduced our GDP growth forecast for 2022 by 1ppt, to 3.5%, and if oil prices rise towards $150pb there is a risk of a much sharper slowdown. This will also be part of creating a slightly looser labour market. All other things being equal, a weaker economy and looser labour market will lead to lower inflation in the medium term, which is the horizon the MPC is most concerned about.
MPC worried about ‘second round effects’
Normally we would expect the MPC to ‘look through’ (that is Bank of England speak for ignore) a jump in inflation caused by energy prices. That’s for two good reasons.
First, energy prices are set on a global or at least continental basis, so raising UK interest rates will do nothing to reduce energy prices and help calm inflation. Second, energy prices tend to be extremely volatile. If the MPC responded to every move in global energy of foreign exchange markets it would be changing monetary policy every day. Instead, the MPC is really concerned with domestically-generated inflation – this is largely driven by wage growth.
The nightmare scenario for the MPC is that rather than gradually falling out of inflation, the ‘one-off’ shock in energy prices causes firms to raise their prices to recoup costs and employees to demand higher wages. Firms then raise prices again to recoup the costs of higher wages – this is the so-called wage price spiral. In this way, an energy shock can translate into domestically generated inflation that lasts for a long time after the initial shock has worn off.
Indeed, household’s inflation expectations over the next 12 months have risen above 4% for the first time since 2011, although the rise in price expectations over the longer term remain more muted.
The immediate decision
Financial markets are pricing in a 100% chance of a 0.25% rate hike, and a small chance of a 0.5% rise. We agree that 0.25% is overwhelming likely, and there is a chance that some members of the committee vote for a 0.5% rise given the recent increase in inflation expectations. But remember the MPC dramatically wrongfooted the market in November and December, so never say never.
The RSM view – flexibility is key
On balance, we expect a unanimous MPC vote for an interest rate rise from 0.25% to 0.50%. The committee has previously made it clear that it is more concerned about the risk from inflation than the danger of weaker economic growth. The recent jump in commodity prices will only heighten that risk, while the unexpectedly large jump in GDP in January will reassure the MPC that the economy was recovering well.
However, given how uncertain the economic outlook is at the minute we suspect the MPC will want to conserve as much flexibility as possible. This could mean that the MPC drops its guidance that a modest tightening of policy is likely in coming months. Our base case is still that there is another rate rise in May, that would take rates to 1.0%, but the crisis in Ukraine could easily mean this is delayed.
In contrast, financial markets still expect the MPC to hike rates to 2.0% by the end of the year. This is because financial markets think that the MPC is so concerned about inflation that it will continue to try to squash any increase in rate expectations. However, we think economic growth will slow sharply in the second half of this year, which would put the MPC in the uncomfortable position of raising rates as the economic damage from the crisis is peaking.