A stubbornly tight labour market, sticky core inflation and a more resilient economy mean the Monetary Policy Committee (MPC) will almost certainly raise interest rates again at its next meeting on Thursday, 2 February. The only question is, by how much?
The vote is likely to be split again. There are two camps within the MPC. The Hawks, including Deputy Governor Dave Ramsden, will point to low unemployment, soaring pay growth and sticky core inflation as the reasons why the MPC needs to do more. The Doves, such as Silvana Tenreyro, will argue that the 340 basis points (bps) of interest rate rises since November 2021 are already enough to bring inflation down to the 2% target within 2 years, and that long lags between an interest rate rise and its impact on the economy mean the committee just needs to be patient.
We think the Hawks will win again and raise interest rates by 50bps, taking interest rates to 4.0%. However, there is still a chance that the committee goes for a 25bps instead.
Focus on the supply side
At the start of every year the MPC updates its supply side assumptions. This year it’s likely to focus on the labour market and the Non-Accelerating Inflation Rate of Unemployment (NAIRU) . NAIRU is essentially the lowest unemployment rate that can be sustained without causing wage growth and inflation to rise.
The Bank’s Chief Economist, Huw Pill, said on 9 January that “in coming to a view on how much monetary policy needs to respond to [these] inflationary pressures, the MPC will need to assess how much the NAIRU has risen and how much of a rise in unemployment will anyway follow from the weakening of demand owing to squeezed household incomes.” Much of this will depend on whether the MPC views the rise in people on sick leave as permanent.
An increase in the NAIRU would suggest that all other things being equal, the MPC will have to raise interest rates by more. However, the MPC is only likely to raise its estimate of the NAIRU by 0.25%, from 4.25% to 4.5%. That’s unlikely to have much of an impact on the outlook for interest rates.
Elsewhere, the resilience of the economy in the second half of last year and the stubbornness of the labour market means the committees GDP forecasts are likely to be revised slightly higher, and the unemployment rate slightly lower. Both moves would also argue in favour of higher interest rates.
Three reasons to raise rates and one reason not to:
Inflation is proving sticky
Admittedly, headline inflation has started to fall, and should continue to fall sharply over the next year. However, core inflation, which excludes volatile food and energy prices, is proving stickier. While headline inflation dropped 10.7% in November to 10.5% in December, core inflation stayed at 6.3%.
This reflected two conflicting changes. Core goods inflation eased further to 5.8%, from 6.3%, driven by cooling pressure in the clothing and recreational goods categories. That probably reflects a surge in demand, the supply disruptions after the pandemic unwinding, as well as firms discounting excess inventory.
The downward move in core goods was offset by a spike in services inflation, which rose to 6.8% from 6.3%. Admittedly, the acceleration partly reflected a spike in airfare prices, which can be extremely volatile. But the broader point is that the evolution of services prices are closely linked to the domestic economy. So, the fact that services inflation is running miles above the 3.3% average for 2000-2019 will be of concern to the MPC.
The labour market is proving stubbornly tight
At just 3.7% the unemployment rate is historically low. The big issue is still the huge number of inactive eligible workers - those who have removed themselves from the workforce. Admittedly, inactivity levels fell by 55,000 on the quarter. But the inactivity rate was still near its recent highs at 21.5% and the shortfall of workers compared with pre-pandemic levels remains sizable, at 335,000.
The tight labour market means growth in regular pay (excluding bonuses) was 6.4% among employees in the three months to November 2022. This is the strongest growth in regular pay seen outside of the pandemic period. Average regular pay growth was even higher, at 7.2% for the private sector – that is miles above the 3%-3.5% that’s consistent with the 2% inflation target.
Admittedly, pay growth is probably near its peak. The slowdown in hiring will lead to less churn in the job market, easing the pressure on businesses to pay more to retain staff. However, the Bank of England will want to see concrete signs of easing wage growth before they consider pausing the tightening cycle. That probably won’t be until Q2 this year, as the labour market lags the real economy significantly.
The economy was more resilient than previously thought
There is now a chance that overall growth in Q4 might be positive. If GDP falls by less than 0.4% month-on-month (m/m) in December, after the surprise 0.1% m/m rise in GDP in November there will still be positive growth. A drop of that magnitude in December is certainly possible, given that all the main business surveys point to falling production, and both heavy snowfall and, to a lesser extent, rail strikes, likely weighed temporarily on activity. But there is now a good chance that the official definition of a recession of two consecutive quarters of negative growth might not be met until Q2 of this year.
The unexpected rise in GDP in November was down to the strength of the services sector, where output rose by 0.2% m/m. Consumer spending has remained strong, even in the face of a record-breaking cost-of-living crisis. Output in consumer-facing services grew by 0.4% in November 2022, following growth of 1.5% in October. The largest contribution to growth came from food and beverage service activities. Admittedly, this is probably partly due to the start of the FIFA World Cup. But consumers have shown a clear preference for spending on experiences rather than goods, with spending on hospitality holding up much better than retail sales.
A shallower recession, either because energy prices stay low or because consumer spending is stronger than expected, would mean that domestically generated inflation is higher. The Bank may then need to offset this by raising interest rates by more and keeping them there for longer.
But, the economy might have fallen off a cliff in January
The main argument against raising rates again is that there is evidence that the economic resilience at the end of last year hasn’t continued this year. The S&P/CIPS Composite PMI fell to 47.8 in January, a two-year low, indicating that the economy is contracting.
What’s more, most surveys are pointing to firms cutting employment as they grapple with surging costs and tepid demand. Weaker demand for labour should eventually push up the unemployment rate and lead to slower wage growth and domestically generated inflation.
Given that interest rate rises typically take up to 18 months to have the full effect, we haven’t seen the impact of the huge surge in borrowing costs last year. The MPC’s own forecasts made in November suggested that interest rates wouldn’t have to go higher than 3.5% to bring inflation down to 2.0% in two years’ time.
The decision
All things considered, we think it will be very hard to slow the pace of tightening in February. As such, it seems most likely that the committee will vote for a 50bps hike taking interest rates to 4.0%. But, we wouldn’t be surprised if there were a couple of votes for no change and potentially one for a 25bp hike.
A more likely time for step-down will be March, when underlying price pressures will probably be turning. We expect that move, which would take rates to 4.25%, to be the final hike of the cycle.
