The Monetary Policy Committee today voted 2-7 in favour of raising Bank Rate by 25bps to 4.5%, with the dissenting members Swati Dhingra and outgoing Silvana Tenreyro voting in favour of a hold. The decision to raise interest rates was widely expected, especially given headline inflation printed almost a full percent above the Bank’s February forecasts in March, while the vote split also came as no surprise given the consistency of dissent by Dhingra and Tenreyro since the November 2022 meeting.
For this reason, the focus of today’s meeting rested on the forward guidance provided by the Bank. Specifically, markets were interested in whether the rate statement retained language that “further tightening would be required” if there were evidence of more persistent inflation pressures and the extent to which the Bank’s projections pushed back on the market implied Bank Rate of 4.8% this year, 4% in 2024 and 3.7% in 2025, which is around 30-40bps than it was in February.
Scalded by the greater inflation persistence in Q1 and more resilient growth conditions, the Bank retained its hiking bias within the rate statement. While this came as no surprise to us, what was interesting is the Bank’s latest round of economic projections, which presented a much more neutral view on the path for interest rates than back in the February meeting.
Notably, the Bank now expects wage growth to remain much higher over the next three years, inflation to fall below the 2% target by a lesser degree and later in 2025 despite the higher conditioning assumption for interest rates, and for the economy to now avoid a recession this year with growth of 0.25%, continuing its expansion over the following two years at a rate of 0.75% per annum. While the Bank did tip its hat to some positive signs, such a marginal loosening in the labour market, an improvement in the economy’s potential level of output and slightly weaker services inflation, this was more than offset by an improved demand outlook. As a result, markets viewed today’s policy decision as hawkish, despite the Bank’s ambition to remain non-committal on future policy decisions.
While this increases the upside risk to our terminal rate expectation of 4.5%, we believe the MPC remains data-dependent.
If labour market and underlying inflation data improves within the next two rounds of data before the June 22nd meeting, as upstream indicators suggest, this should give the core of the Committee confidence that monetary policy is restrictive enough to pause its hiking cycle after twelve consecutive rate hikes.
May’s projections are much more inflationary than February, compounding expectations for more tightening
Given both the hotter-than-expected recent CPI readings and the vastly improved growth outlook, today’s Monetary Policy Report saw a significant upwards revision to the path for CPI over the medium term despite a higher conditioning path for interest rates. Whilst the February MPR did forecast inflation in Q2 2023 to be around 0.3pp higher than is now projected in the May MPR, this adjustment is largely the result of the distortionary effect of energy price guarantee. Beyond the very short term, the BoE does not now expect inflation to fall below its 2% target until around the end of 2024 or the beginning of 2025. This is in sharp contrast to just three months ago, when the MPC foresaw reaching its target by Q2 2024, and for inflation to stay below target for the remainder of the forecast period. The May projections now see inflation at 5% in 2023, up from 4%, 2.25% in 2024 vs 1.5% previously and 1% in 2025 vs 0.5%. This upwards adjustment to the Bank’s CPI projections is reflective of a labour market that is expected to continue to be more robust than previously anticipated, even in the face of an upgrade to the expected degree of monetary tightness. The conditioning assumption for Bank Rate is up around 30bps across the projection period in this latest set of forecasts, now at 4.8% in 2023 vs 4.4% in Feb, 4% in 2024 vs 3.7% and 3.7% in 2025 vs 3.4%. Despite this, the level of unemployment is now only expected to rise to 4.5% by 2026, some way below the peak level predicted in the February MPR of 5.1% unemployment in 2025. More specifically, the unemployment rate is expected to rise above the MPC’s estimation of NAIRU (4.25%) in the second half of 2024 versus H1 2024 previously. This greater labour market strength is also reflected in expectations for wage growth, which have also been upgraded, with tighter labour markets producing a corresponding boost to labour pricing power. Average weekly earnings are therefore also expected to be higher than forecast in February, although the forecast for this year is consistent with March’s minutes, with growth of 5% now expected in 2023 against an increase of 4% anticipated February. Upgrades were also visible further out with 3.5% and 2.5% seen for the 2024 and 2025 figures versus 2.5% and 1.5% previously. The combination of a tighter labour market, higher wages and therefore stickier inflation is a dynamic that the BoE have consistently flagged as an upside risk to their forecasts.
With the MPC now choosing to revise their projections upwards across these measures, it suggests that monetary policy may be set to stay higher for longer than markets are currently anticipating.
The Bank of England significantly upgraded their medium-term inflation forecasts on the back of a more robust outlook for the labour market and demand
Another area of interest for market participants was on the Bank’s latest growth projections. Following the Spring budget, the Bank had estimated that fiscal policy would contribute around 0.3pp to growth over the entirety of the 3-year projection period, with Chief Economist Huw Pill recently alluding to the fact that most of this would be via supply-side improvements. While the Bank estimates that this will now add around 0.5pp to growth, this is vastly outweighed by a better growth outlook given the reduced drag on household incomes. This is best displayed by the Bank’s new projections for the output gap, which now expect only a slight drag on inflation in 2024 and for the gap to widen to -1% in 2024 compared with February’s projections of -1.75% in 2024 and -2.25% in 2025 respectively. This now suggests that the economic outlook, although still weak, will provide a lesser disinflationary drag than previously assumed.
Again, this is supportive of the view that Bank Rate will be held at much higher levels as markets imply.
Bailey and Co stress data dependency in the press conference, but this didn’t pull market expectations back in fully
Throughout the press conference, Governor Bailey and Deputies Broadbent and Cunliffe stressed that the path for interest rates will remain dependent on incoming data and the MPC’s perceived judgement of inflation persistence. This isn’t out of whack with other central bank communications during this phase of the tightening cycle. Bailey even went as far to say that the Bank will not be giving a “directional steer” on interest rates, “just as it did last time”. However, this didn’t completely temper the more hawkish view taken by markets following the Bank’s discrete guidance provided by the latest round of economic projections. After the release of the MPR, expectations of the BoE’s terminal rate drifted back towards 5%, with the implied November rate jumping 5bps to a seven day high of 4.9%. Throughout the press conference, this move has only partially retraced.
Overall, while today’s BoE meeting underscores the upside risks to our BoE terminal rate forecast, we continue to believe that positive upstream inflation developments will provide the BoE with a basis to pause rates as early as June.
After all, prior to the next BoE decision, policymakers will have access to another two rounds of inflation and wage data. Given signs of improvement in more timely calculations and leading indicators, we believe the threshold of “more persistent pressures” won’t be met. However, upside risks to this view have increased. Our view on the BoE moving forward reinforces our neutral medium term forecast for GBPUSD of 1.25 over three months. As we’ve noted in recent commentary, we are looking towards the next rounds of UK data to trigger the slight retracement in sterling as opposed to BoE commentary specifically.
Simon Harvey, Head of FX Analysis
Nick Rees, FX Market Analyst