The Bank of England today voted 6-3 in favour of raising the Bank Rate by 25 basis points to 1%. The dissenting members (Haskell, Mann and Saunders) all opted for a 50bp increase, citing concerns over firms’ pricing behaviours and expectations of a tighter labour market running the risk that higher inflation will become embedded.
With the Bank Rate at 1%, the Bank of England has asked staff to prepare a strategy for active Gilt sales ahead of August’s meeting. This was largely expected as the current volatility in bond markets warrants a more cautious approach to the novel policy. On the surface, today’s interest rate announcement leant on the hawkish side of expectations, with no members dissenting against further rate increases and the bias in the Committee, as measured by the voting split, favouring front-loaded action. However, financial markets struggled to buy this narrative as the Bank’s forward guidance on the path for interest rates eluded to an incoming pause in the tightening cycle. The wording around “further tightening in monetary policy” was weakened to only “most members” now taking this view, suggesting there is more than one dovish dissenter. In addition to this, markets have been forced to recognise the increased growth risk to the UK economy, which suggest that a further rise in inflation above projections, or a sharper tightening in monetary policy, would tip the UK economy into a recession as per the Bank’s projections.
The Bank currently projects inflation to average slightly over 10% at its peak in Q4, with 2023 expected to bring an average inflation rate of 2.94% and flat growth. Should the Bank follow the market-implied path, which sees rates rise to 2.5% by mid-2023, the Bank projects GDP will drop by 0.25% year-on-year in 2023 and excess supply to equal 2.25%.
In our opinion, today’s announcement lays the groundwork for an upcoming pause in the Bank’s hiking cycle. In combination with the constant rate inflation projections of 2.94% and 2.16% over the two and three-year horizon, which suggests a further tightening in policy is required, today’s BoE meeting strengthens our prior view that the Bank will embark on a further 25bp hike at June’s meeting before entering a reflection period over Q3. We expect the Bank Rate to be lifted a further 25bp in Q4, likely at November’s meeting, but our conviction of the Bank Rate ending the year at 1.5% as opposed to 1.25% is low and largely depends on how households real incomes hold up in H2 2022.
Bank of England prioritises anchoring inflation expectations, but growth conditions could warrant a rate cut in 2023
The main rationale behind today’s BoE move was to mitigate against second-round inflation conditions, which in the MPC’s view, pose a larger risk to the macroeconomic outlook in the medium-term than the impact of interest rate rises on growth. Deputy Governor Ramsden argued this by stating that the impact of slightly higher interest rates on household real incomes was a fraction of the impact posed by the inflation shock. By taking an earlier stance, the Bank is hoping that the current level of interest rates can help anchor inflation expectations, with the sharp downturn in economic growth set to keep the prices of demand-sensitive goods at bay. Under this outlook, it is a case of then waiting and hoping for supply-side inflationary pressures to stabilise. Under the assumption of a stabilisation, the large inflation forces currently at play will soon provide substantial disinflationary pressures due purely to technical factors towards the back-end of 2022 and into early 2023.
In summary, the Bank has relayed through multiple forms of communication that interest rates aren’t expected to rise anywhere near that implied by money markets. In addition, the precarious position monetary policy currently finds itself in means that the Bank can’t discount cutting interest rates next year should economic conditions deteriorate substantially.
That is, inflation expectations remain anchored but the pressure on the consumer forces economic growth to contract more than expected, suppressing firms margins further and resulting in a loosening in the labour market. While we long argued that money markets had some way to go in correcting back to this lower rate profile reality that has been in place ever since the March meeting, we didn’t foresee such a substantial decline in UK Gilt yields– a more decisive driver of GBP price action. The near 25 basis point reduction in front-end UK Gilt yields in response to today’s BoE meeting, in our view, reflects not only a lower peak in near-term interest rates in the UK of around 1.25-1.5%, but increased recession risks in 2023, and in turn, the heightened probability of an interest rate cut. The drop in Gilt yields hasn’t been isolated to the front-end of the curve, however, with 10-year yields also falling by over 10 basis points. The aggressive repricing in the Gilt market has weighed on the pound, sending it to its lowest point since June 2020 against the dollar and December 2021 against the euro. The diverging pace of policy tightening, specifically between the UK and the US, should see GBPUSD remain under pressure and in the mid-1.20 range, in our view.
It is worth noting that despite the increased recession risk, fixed income instruments are still some way off signalling that this is the base case: the Gilt curve is yet to invert beyond a flattening in the 6-12 month spread, while the spread in implied year-end rates in SONIA futures still points towards a further 25bp hike in 2023.
Gilt yields tumble as fixed income traders wake up to a more dovish BoE and the heightened probability of an economic contraction in 2023, sending GBPUSD plummeting
Simon Harvey, Head of FX Analysis