MPC hikes rates but takes a more dovish tone

The Monetary Policy Committee (MPC) still desires to bring about price stability, and so has raised interest rates from 0.50% to 0.75%. Rates are now at their post-pandemic high.

The vote at Thursday’s meeting wasn’t unanimous, however. One member voted to keep interest rates at 0.50%, and no one voted to raise rates by 50bps compared to four votes in February. The language in the minutes was also a little more bearish than it was in February.

Admittedly uncertainty reigns but the dovish shift in tone suggests that financial markets are being overly ambitious in expecting interest rates to reach 2.0% by the end of this year.

Inflation growing, but so is the damage to the economy

The MPC upped its inflation forecast from a peak of 7.25% in April to ‘around 8% in Q2,’ and it warned that if gas and electricity prices remain high then Ofgem may have to significantly revise up its energy price cap in October, which could cause a second peak even higher than April’s.

This looks about right to us, as we expect inflation to rise to 8.3% in April when the 54% increase in the utility price cap comes into force. And there is a real possibility that inflation hits 9% in October.

At the same time, the MPC also revised down its economic forecasts, saying the ‘impact on real aggregate income is now likely to be materially larger than implied by the projections in the February Report, consistent with a weaker outlook for growth and employment, all else equal.’ Indeed, we have already revised down UK GDP growth by 1% to 3.5% – and the risks to even this subdued number are to the downside.

Energy prices more important than interest rates

We would normally expect the MPC to ‘look through’ (that’s Bank of England-speak for ‘ignore’) a jump in inflation caused by energy prices. However, the MPC is concerned that, rather than gradually falling out of inflation as energy prices stop rising, the ‘one-off’ shock in energy prices causes: (a) firms to raise their prices to recoup costs; and (b) 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.

But the tricky issue is, increases in the cost of energy, which the UK is a net importer of, act like a tax on consumers and businesses, reducing the amount the consumers have to spend and businesses have to invest. All else being equal, this will lower inflation in the medium term. So, the MPC finds itself in the tricky positions of trying to keep inflation expectations under control, without subduing growth so much that inflation falls below target in a few years.

How far will interest rates rise?

The more dovish tone of the minutes caused markets to slightly revise down their interest rate expectations. Admittedly, the committee stuck with its guidance that ‘some further modest tightening in monetary policy might be appropriate in the coming months,’ but also said ‘there were risks on both sides of that judgement depending on how medium-term prospects for inflation evolved.’

However, financial markets are still pricing in another five interest rate hikes this year, which would take rates to 2.0% by the end of 2022.

In our preview of the MPC policy decision, we wrote that the extreme volatility at the minute meant that the MPC would want to conserve as much flexibility as possible. And the MPC said it ‘would review developments in the light of incoming data and their implications for medium-term inflation, including the economic implications of recent geopolitical events’. Until the pervasive uncertainty surrounding the current domestic and global economic outlook abates, it is almost impossible to have a sensible idea of where interest rates will end up.