We’re expecting that the Monetary Policy Committee (MPC) will vote unanimously to raise interest rates at its next meeting on 3 February. Along with lifting interest rates from 0.25% to 0.50%, the MPC may also stop reinvesting the proceeds from maturing gilts and allow its balance sheet to shrink gradually over the next few years. Our forecast is that another rate rise in autumn will send interest rates to 0.75% by the end of the year.
Bank of England governor, Andrew Bailey, has denied an accusation from the Treasury Committee that he behaved ‘like an unreliable boyfriend’ after the MPC wrongfooted the market at both of its previous meetings. The MPC should be prepared for more awkward conversations if it decides to both raise interest rates and downgrade its economic forecasts. However, the message is more likely to be that its concerns are about the threat from inflation, rather than the risks to the economy.
Inflation rising, growth weakening
The MPC will update the economic forecasts it made in November. Since then, the economic conditions have deteriorated. The emergence of omicron in late November, and the imposition of further restrictions on socialising, means that GDP almost certainly fell in December and was probably flat in January.
At the same time, even though energy prices have fallen back from their December peaks, inflation surprised to the upside. The 5.4% rate of CPI inflation in November was significantly higher than the 5% the MPC had expected. What’s more, it now looks like it will peak at between 6.5% and 7% in April, way above the 6% peak the MPC predicted.
We expect it to revise down its forecast for GDP growth in Q4 2021 by around 1.5%. Admittedly, we think that most of omicron’s damage to economic activity will be made up in February as the number of people on sick leave falls, workers return to offices and consumers go back to shops and bars. This may bolster growth at the start of Q1, but higher inflation could cause the committee to revise down its growth forecast for 2022 as a whole from 5% to around 4.5%.
Meanwhile, the labour market has been a little stronger than it anticipated in November. The unemployment rate fell to 4.1% in November, only slightly higher than its pre-crisis level. Pay growth is also a little stronger than the MPC previously envisaged. The MPC will probably revise down its unemployment rate forecast from 4% to 3.75%, heightening concerns that wage growth will feed through into higher medium-term inflation.
The immediate decision
Financial markets are pricing in a 97% chance of a rate hike, but whether the MPC decides to hold interest rates at 0.25% or raise them to 0.50% it’ll have a convincing case either way:
The hawks’ case
The more hawkish members of the committee will argue that an interest rise is clearly needed, as inflation is rising more quickly than the committee had previously thought and now looks set to peak at almost 7% – more than three times its 2% target. Failing to increase interest rates now could lead to a loss of credibility for the central bank and an increase in inflation expectations, which have been rising recently. This could feed through into higher medium-term inflation, which would require bigger increases in interest rates further down the line to re-establish credibility and bring inflation back under control.
What’s more, the economy returned to its pre-crisis level in November – although it probably fell back below in December – and the labour market is tight, with wage growth above levels that the MPC thinks are consistent with its 2% inflation target. Huw Pill, the Bank of England’s chief economist said in December that, ‘the pressures we still see building domestically within the labour market, in services, prices, inflation and so forth, need to be addressed by somewhat tighter policy and a somewhat higher bank rate.’
The doves’ counter-argument
Inflation is being primarily driven by energy, fuel and food prices – these three categories accounted more than half of the 5.4% rise in the price level in November – and those are largely determined by international markets. As a result, raising interest rates will have little impact on inflation. In fact, given that inflation is driven by a shortage of goods and energy, higher interest rates could exacerbate the problem by making it more expensive for firms to invest.
In addition, consumers are facing a 50% jump in energy bills in April, along with a hike in national insurance rates, which will weigh on consumer spending and GDP growth. Adding higher interest payments to these costs would only worsen the outlook for consumer spending, and damage the economic recovery.
The RSM view
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. Now that the economy has returned to its pre-crisis level, it is appropriate to start withdrawing some of the emergency stimulus introduced during the pandemic.
However, we believe financial markets are overly confident in expecting four interest rate hikes this year. This is largely because the MPC has said it will stop reinvesting the proceeds from maturing bonds once interest rates reach 0.5%. Doing that will put upward pressure on long-term rates, while simultaneously creating additional policy space at the short end of the curve to carefully manage the pace and magnitude of increases in the policy rate. The logic here is that slightly higher long-term rates reduce the need to hike rates at the front end of the curve.
In technical terms, to bolster the economy during and after the financial crisis and the pandemic, the central bank has removed duration risk in the private sector (purchasing assets) to reduce long-term rates. By ending the reinvestment of maturing proceeds and allowing assets to run-off the balance sheet, the central bank is adding duration risk back into the private sector, which will permit longer term rates. Approximately £28bn in gilts will mature in March, so if the Bank of England allows these to roll off it will shrink its balance sheet by around 3%. It will then continue to decline gradually as gilts mature. Another £9bn in gilts will mature over the course of this year.
The maturing of gilts will create a steeper yield curve, as well as cool excess and speculative demand in the housing market. It will also help address the inflationary pressures that are moving into the cost of shelter via rental inflation, which was at the highest level since early 2016 in November. Left unattended, that type of inflation can prove stickier and more difficult to reverse, barring a recession. That’s why now is the time to use the balance sheet tool to address inflation.
The MPC has said that it won’t start actively selling gilts until Bank rate reaches 1.0%, which we don’t think will be until 2023 at the earliest.
This underscores our end-year target on the US 10-year yield of 1.5%. The combination of real factors, such as demographic changes, reduced returns on investment, a build up of global savings and roughly 2% long-term growth rate, will all continue to damp longer term rates despite the current policy challenge of inflation.