The Bank of England met market expectations today by hiking rates 50bp to 1.75%, exceeding our base case in doing so.
Although the decision seems less dramatic in a global context that has seen peer central banks hike in large steps – the BoC hiked by 100bp in July, the Fed has been hiking in 75bp increments since June, and even the ECB hiked by 50bp two weeks ago– the magnitude of today’s decision shouldn’t be understated.
In hiking 50 basis points, the Bank has just conducted its largest interest rate increase since monetary policy gained its independence in 1997.
Furthermore, the move by Governor Bailey and six of his colleagues, given Silvana Tenreyro dissented in favour of a 25bp hike, is set against an expectation that the UK economy is heading into a protracted recession in the coming months under the pressures of higher inflation and tighter monetary policy. From a market perspective, we have long argued that the BoE’s decision to hike either 25bp or 50bp is rather irrelevant. Instead, the Bank’s projections and overall communications would lead to an underwhelming meeting for traders. This was ultimately the case as the various forecasts supplied by the Bank suggested that the overall implied money market curve was too hawkish, and even in the event that the BoE was forced to take rates to 3% by the second quarter of 2023, the economy would be under substantial pressure such that higher rates will unlikely be met by greater investment inflows and sterling strength.
In response to the initial rate announcement and set of projections in the Monetary Policy report, the pound fell 0.7% against the dollar as Gilt yields started to plunge.
This momentum was sustained throughout the press conference as Governor Bailey highlighted the Bank’s appetite to hike into an economic downturn in order to mitigate against a worst scenario: persistent above-target inflation. Today’s decision endorses our bearish near-term forecast for GBPUSD and our expectation that upside in the pound will likely have to await a broad depreciation in the dollar as opposed to relying on domestic factors.
GBPUSD drops almost a percentage point following the BoE’s decision to hike rates by 50bp before retracing the move lower on broader USD weakness
Under all projected scenarios, the Bank still see’s inflation falling below 2% over the medium-term, suggesting rate cuts will be on the horizon irrespective of near-term policy
Despite the hawkish rhetoric from Governor Bailey and Co in the press conference, the Bank of England’s economic projections speak loudest. Owing to the elevated level of uncertainty due to the difficulty in forecasting energy markets, the Bank provided a larger number of economic projections under numerous scenarios today. The fundamental projections, which are based upon futures pricing for energy markets for the coming six months with pricing held flat from thereon, see inflation falling below 2% in two-to-three years time. When conditioned upon the market implied path for interest rates, which see’s Bank Rate rising to 3% in 2023 Q2 before falling to 2.2% in three years, BoE staff see inflation falling below target to 1.5% YoY by the end of 2024. When conditioned on a constant rate of 1.75%, the Bank sees inflation at 2.5% by that point, suggesting further interest rate rises are required in the coming meetings, with inflation falling to 1.3% in 2025.
The Bank’s latest benchmark (annual) projections foresee higher inflation and a recession persisting the entirety of 2023
In the Bank’s first alternate scenario, which factors in a reduction in energy prices to above pre-pandemic levels in line with their futures curves, headline CPI is projected to be over a percentage point below the baseline forecast in 2024, with a further 0.5% undershoot in the three-year horizon.
Additionally, in a scenario where there is greater persistence in domestic price setting, headline inflation is only 0.7 percentage points above the baseline projection in two years’ time, while falling below the 2% target in 2025 accordingly.
Essentially, the latest batch of inflation forecasts from the Bank of England imply that policy rates are expected to fall towards the back-end of the Bank’s projection period, with greater inversion of the UK rates curve subject to tighter near-term policy.
Interest rate expectations for H2 2023 as per SONIA futures drop throughout today’s meeting (yield = 100 – price)
We now look for a second 50bp hike in September, followed by one further 25bp hike in November
Given the majority of the MPC is seemingly comfortable in aggressively hiking rates going into an economic downturn, we now think the BoE will hike rates by a further 50bp in September, before conducting one final 25bp hike in November to bring Bank Rate to 2.5% by year-end. While this remains below money-market pricing, we believe that in the absence of further fiscal support for households, the downturn in economic conditions from November onwards will restrict firms’ ability to pass-on higher costs, while the reduction in labour demand will ease fears once and for all of a wage-price spiral. However, risks are currently tilted to the upside as the Conservative leadership race points towards more support for households amid the cost of living crisis. Given the Bank’s explicit target to dampen consumer demand, this will naturally be met by a corresponding increase in interest rates if legislated.
Simon Harvey, Head of FX Analysis