As expected, the Monetary Policy Committee (MPC) doubled down on its desire to show that it is serious about price stability by raising interest rates from 0.25% to 0.50% on Thursday, signalling that it will allow its balance sheet to shrink. It took things a step further by saying that four members of the committee voted for a 50bp rise and that it would start to actively sell its stock of corporate bonds. Given another hawkish shift in tone, we now expect two further rate hikes this year, probably in both March and May, with interest rates finishing the year at 1.0%.
Inflation surging but spare capacity widening
The MPC dramatically upgraded its forecast for inflation to close to 6% in February and March, before peaking at around 7.25% in April. That’s around two percentage points higher than it expected in November. What’s more, the committee expects inflation to be further above the 2.0% target for all of this year and 2023. The 54% rise in Ofgem’s utility price cap and the Chancellor’s handouts to households, both announced earlier today, don’t really change much compared to our previous forecast.
At the same time, the Bank also revised down its GDP growth forecasts for 2022 (from 3.75% to 3.25%), adding that a weaker economy would mean that a degree of excess supply would open up in the second half of this year.
Energy prices more important than interest rates
The outlook for inflation over the next two years depends more on how energy prices move over the rest of the winter, rather than any action the committee takes.
The uncertainty is so great that the MPC presented two scenarios. One based on energy prices remaining high, in which consumer price index (CPI) inflation was projected to fall back to a little above the 2% target in two years’ time and to below the target by a greater margin in three years. And secondly, one in which energy prices followed forward curves throughout the forecast period. In this scenario CPI inflation would be around 0.75 percentage points below the 2% target in two and three years’ time.
Indeed, the risks that energy prices could fall over the next year and lead to a much sharper fall in inflation was a key reason five of the nine MPC members voted to raise interest rates by 0.25% rather than 0.5%.
Interest rates still the tool of choice
The MPC confirmed that it will stop reinvesting the proceeds from its maturing bonds from now on. As a result, the Bank's balance sheet will shrink by £27.9bn in March. In total over 2022 and 2023, just over £70bn of UK government bonds held by the APF would mature, and over 2024 and 2025 around a further £130bn of bonds would mature. What’s more, the MPC said it would unwind all of its £20bn stock of corporate bonds by the end of 2023.
This shrinking of the balance sheet is known as quantitative tightening (QT). This is a form of monetary tightening, and so should serve to dampen inflation at the margin. Given the MPC thinks quantitative easing (QE), which is buying bonds, is more effective during times of financial market turmoil, we don’t expect QT to have much of an impact on financial markets or inflation.
So, it shouldn’t be too surprising that the committee reaffirmed its preference in most circumstances to use Bank Rate as its active policy tool when adjusting the stance of monetary policy. This essentially means that if the MPC feels that monetary policy needs to be tightened further it will do it by raising interest rates rather than by increasing bond sales.
How far will interest rates rise?
Financial markets have priced in another four interest rate hikes this year, which would take rates to 1.5% by the end of 2022.
However, the MPC signalled that markets may have been premature in doing that, saying that if interest rates rose that far and that quickly then inflation would settle at just 1.6% in three years time (Q125) ahead with a wide margin of spare capacity (-1%) and the unemployment rate would rise to almost 5%.
But it also said that if interest rates stay at 0.5% inflation would still be around 2.5% in 2024. What’s more, the committee also reintroduced its guidance that rates are likely to rise in coming months.
So, it’s pretty clear that the MPC thinks four is too many hikes. But it’s also clear that our forecast for just one more hike this year in August is too dovish and doesn’t reflect the urgency being expressed by the committee. In particular, the MPC appears very keen to front-load hikes to guard against the risk of inflation expectations becoming unanchored.
Whether the next move comes in March or May is uncertain. But the experience of the end of last year where the MPC hinted at a move in November and then hiked in December, suggests that it will take the opportunity to raise rates by 25bps in March, assuming the economic data evolves in line with the MPC’s forecasts.
Another move in May is also likely, which is the point at which inflation concerns are set to be at their most intense after inflation has breached 7% in April. That would take the benchmark rate to 1%, which is where we expect the committee to stop as the inflation outlook becomes more benign in the second half of the year.
