The Bank of England is the first major central bank to raise interest rates after the pandemic. By an 8-1 vote on Thursday, the Monetary Policy Committee (MPC) raised the base interest rate by 0.15 percentage points to 0.25%. but maintained its bond buying target at £895bn. However, the market’s pricing in of a further three rate hikes by the end of 2022 looks premature to us.
The emergence of the omicron variant and slump in GDP growth to just 0.1% m/m in November convinced many that the MPC would hold its fire in December. However, the strength of the labour market, the drop in October unemployment to just 4.2%, and surging inflation, which reached 5.1% in November, appear to have trumped concerns over omicron and slowing growth. The Bank of England downgraded its GDP forecast for the last quarter of this year by 0.5% and raised its peak inflation forecast from 5% to 6%.
The MPC reminded us that its remit is clear: ‘…the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework.’ This is Bank-speak for, ‘inflation is always our primary concern, economic growth is secondary.’
So, the MPC is now finally worried enough about inflation that it feels it can’t wait to see the effect of omicron. The MPC highlighted that, ‘the labour market was tight and had continued to tighten, and there were some signs of greater persistence in domestic cost and price pressures.’ This probably refers to services inflation, which has been rising recently, although it remains well below goods inflation. The committee also dwelt on the upside risks to the inflation outlook posed by omicron, which will put further pressure on global supply chains and delay consumers moving away from purchasing goods and back to services.
Smart move or risky gamble?
Whether today’s rate hike turns out to have been the right call will largely depend on how omicron impacts the economy. If the damage to the recovery is limited, the MPC will have made the right choice. But Infection rates are rising sharply, GDP growth was just 0.1% m/m in November, and data out this morning suggests that GDP will shrink in December and January. There is also the risk of another lockdown, which could plunge the UK back into recession. Should the economy struggle to recover under that weight, the rate hike will be seen as an unnecessary further burden.
The RSM view
Assuming there aren’t further restrictions over the winter and omicron is a blip, more rate hikes are probably in the pipeline. Indeed, ‘the Committee continued to judge that there were two-sided risks around the inflation outlook in the medium term, but that some modest tightening of monetary policy over the forecast period was likely to be necessary to meet the 2% inflation target sustainably.’
However, inflation should fall sharply in the second half of 2022. And if energy prices follow a similar path to the futures curve, inflation could be below target in 2023.
Financial markets are expecting another rise in February and then two more to take interest rates to 1.0%. But we expect the next move will be from 0.25% to 0.50% in May, and that’s likely to be it for 2022. This is not least because, once interest rates reach 0.5%, the Bank’s balance sheet will start shrinking as it stops reinvesting the proceeds from maturing assets. This is a form of monetary policy tightening, and the MPC will be wary of raising interest rates too quickly as it’s removing liquidity from the market.
The big picture is that, even if interest rates do rise more quickly than we expect, monetary policy will still be very accommodative and real interest rates, which are what really matters for savings and investment, will remain negative for a long time yet.