Long ReadMar 20 2023

Where does BoE go from here as next interest rate decision looms?

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Where does BoE go from here as next interest rate decision looms?
The Bank of England cannot ignore the risk that further economic tightening poses for growth. (Photo: Ben Stansall/Getty Images)

On February 1, the Bank of England’s Monetary Policy Committee voted 7-2 in favour of a 10th consecutive interest rate increase. 

This decision, which raised rates by 50 basis points to 4 per cent, coincided with the clearest signal yet that the base rate might be nearing its peak when the BoE said it would only raise rates further “if there were to be evidence of more persistent [inflationary] pressures”. 

A fortnight later, consumer price index data revealed that inflation had dipped by 0.4 per cent to 10.1 per cent – a five-month low in the UK. As a sharper decline than many experts had predicted, some analysts now think the central bank will hit pause.

These views were strengthened on February 16 when BoE chief economist Huw Pill, speaking at Warwick University, warned that there is a risk of “over tightening” for the central bank now.

However, UK price pressures remain at higher levels than in other economies, mostly due to energy costs. Meanwhile, average pay is growing at its fastest rate for more than 20 years. Clearly, a balance must be struck where growth is concerned, given that the UK economy is set to be the only major economy to shrink in 2023.

Meanwhile, further rate increase risk creating a deeper recession, especially as the full impact of previous hikes have still not yet been felt.

This was demonstrated by the Silicon Valley Bank crash earlier in March, and the Credit Suisse takeover last week, which many analysts argue was caused by the speed at which rates have increased, potentially indicating weakness at the heart of the financial system.

Clearly, the BoE is in a difficult position as March’s interest rate decision looms, so where does it go from here?

The battle with inflation

First, what inflationary pressures will be at the forefront of the MPC’s mind in the months to come?

The labour market is one example. For the most part, BoE governor Andrew Bailey and his colleagues have placed much of the blame of the upward pressure on wages on a shortage of workers – with vacancies dipping across the country, this inflationary pressure might be expected to be receding. 

According to the Office for National Statistics, household bills account for 26.7 per cent of the current rate of inflation, so inflation will recede at pace if they start to decline.

However, statistics show that the problem remains, with January’s wage data coming in hotter than expected. In the fourth quarter of 2022, average earnings were 6.7 per cent higher than in the same period in 2021, presenting a major problem for the BoE – when salaries rise, businesses typically raise prices to compensate, creating an inflationary spiral.

For the MPC members who believe in further tightening, this adds credence to their argument.

Elsewhere, energy costs will be monitored closely. According to the Office for National Statistics, household bills account for 26.7 per cent of the current rate of inflation, so inflation will recede at pace if they start to decline. Currently, however, the cost for consumers remains elevated, even though wholesale prices have dipped.

Though more difficult to quantify and monitor, the effect of government fiscal packages throughout the pandemic – such as the furlough scheme – presents further difficulty.

In congress with a sharp rise in personal savings during the pandemic, consumers were left with a lot more money to spend when society reopened. The result was a strong economic recovery, but, combined with the hangover of pandemic supply constraints, this resulted in bottlenecks and higher prices.

Need to balance with growth 

Despite these inflationary pressures, the BoE cannot ignore the risk that further economic tightening poses for growth. 

Last year, the UK economy avoided a recession by the barest of margins, with gross domestic product declining by 0.5 per cent in December. This came after the economy shrank by 0.2 per cent in the third quarter of 2022. While the UK is not yet in a technical recession, growth is too weak to avoid a significant economic downturn.

According to the International Monetary Fund, the UK economy will shrink in 2023 and perform worse than other major economies, including Russia. But with the UK lagging behind, economists are arguing that further interest rate rises may result in a deeper recession.

Similarly, as a result of quick successive interest rates increases, there are now concerns that there are growing signs of financial stress that can be linked to the growing cost of borrowing.

The Silicon Valley Bank collapse, for instance, could be indicative of a wider issue within the financial system, meaning that the BoE could be forced into pausing its hiking cycle at an earlier date than initially planned in order to protect the banks, as well as the many UK tech start-ups that have been caught up in the SVB fallout.

What can we expect in the months to come?

Before the SVB crash, the markets had priced in further rises, peaking at 4.9 per cent for year-end. However, the probability of a 0.25 percentage point increase has now dropped from close to 100 per cent to 64 per cent, with the argument being that banks will exercise their own caution when issuing loans in the coming months over financial stability concerns.

As such, fewer loans will be delivered, alleviating the pressure on the central bank to cool the economy.

That being said, the crisis faced by another bank this week – namely Credit Suisse – muddies the water further for the MPC. As such, while the BoE have insisted that the UK’s financial system is ‘safe and sound’ the more dovish members of the MPC may see last week’s events as further reason for hitting pause on further rate rises for the time being.

As such, the BoE still finds itself at somewhat of a crossroads.

On the one hand, it could pause its hiking cycle in the hope that inflation has peaked to boost growth, and protect the banks. Some economists predict that interest rates will peak 25bp lower than the market expectation at 4.25 per cent. That makes sense and a 4.5 per cent peak looks ambitious.

In this instance, the delayed effects of tightening could encourage the MPC to cut rates by 25bp in the fourth quarter. On the other hand, it may try to grind inflation into the ground and raise interest rates hawkishly.

For the longer-term health of the economy, historically speaking, this is the best thing to do. This sentiment was echoed by BoE policymaker Catherine Mann recently, when she argued that “material upside risks” remain for sticky inflation. However, it is a bitter pill to swallow and could result in a deep recession. 

What is certain is that the MPC will want to see inflation’s downward trend continue before it hits pause on the hiking cycle. Everything hinges on whether vacancies carry on dipping, wage data starts to cool, and energy prices begin falling.

However, perhaps the weakness of the banking system and the need to protect it will now replace inflation as the main priority for the BoE, and indeed the other central banks around the world. With inflation on the run, the MPC will want to ensure that they do not take their foot off the brake too early.

But, by pausing now, the BoE can allow the UK’s financial system adjust to the ‘new normal’ of higher rates and recover from the turmoil faced by other banks in the last few weeks, delivering some much-needed stability amidst the cost-of-living crisis.

As a result, the markets have priced in an almost equal probability between a 0.25bps increase and no change, indicating how much of a difficult decision the MPC have to make on Thursday.

Opportunities for investors

Across the pond, the SVB crisis will perhaps have a more significant impact on central bank policy than in the UK. Indeed, despite policymakers at the Federal Reserve hinting that they will need to keep gradually raising interest rates to combat inflation effectively just weeks ago, inflation has cooled further and turmoil has ravaged the banking system.

As such, the probability of the Fed raising rates further fell close to zero last week, but expectations continue to shift rapidly. For currency investors, a Fed pause could see strength for GBP in the short-term, so should be monitored closely when the FOMC meets on Tuesday and Wednesday.

In terms of the other major central banks, such as the European Central Bank (ECB) – whose economy is perhaps more resilient in the face of the cost of living crisis – it is likely that rates will rise again at their next meetings (perhaps even the Bank of Japan, which has held firm to an ultra-loose monetary policy up until now, is looking to slowly transition to interest rate normalisation).

Therefore, the differences in approach from the Fed, the BoE and other major central banks means volatility in the FX markets, which is a good thing for investors – indeed, as some countries move faster than others on interest rate changes, traders should monitor currency divergence closely.

Even as inflation dips, it is clear that there are a growing number of factors for the BoE to be mindful of ahead of their meeting on Thursday. As such, while inflation continues to be a priority for the MPC, the potential weakness in the banking system may be too much of a threat to the long-term health of the economy if they were to hike rates again.

Therefore, if inflation continues to cool on Wednesday, a no change decision on Thursday would be an increasingly likely outcome.

Giles Coghlan is chief market analyst at HYCM