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On one hand, the central bank does not want to choke off the recovery, with UK growth slowing and the full impact of unwinding the furlough scheme as yet unknown. On the other, with the persistence of higher inflation, the BoE faces a credibility challenge with various members of the Monetary Policy Committee (MPC) having taken a more hawkish stance. Ultimately, they will want to avoid a UK version of a ‘Trichet moment’ or being labelled another ‘unreliable boyfriend’. While we will only know in hindsight, the market has already made its judgement.
*Implied by market pricing
Governor Bailey has previously come under criticism for his shifting messages over negative interest rates, but we don’t think his remarks are as clumsy this time. Instead, we believe that the market has taken them out of context, disregarding Bailey’s comments about the limitations and lack of desire for policy to fix supply-side shocks and ‘the hard yards’ ahead.
Whether his recent hawkish comments were purposefully so, or if he over-egged the pudding, the Bank of England has been clear that it plans to exit extraordinary monetary policy by raising rates first, and when rates reach 0.5%, switch to focus towards reducing its balance sheet.
Taking a cue from Ben Broadbent’s speech about US quantitative tightening in 2018, “rate rises and any tightening effect of shrinking the balance sheet should be seen as substitutes. More of the latter would mean less of the former“. In other words, a decisive initial rate hike doesn’t necessarily warrant the succession of hikes priced swiftly afterwards. Figure 1 shows the degree to which market pricing has moved over the last month:
Source: Bloomberg, Janus Henderson Investors, as at 20 October 2021.We expect more clarity from the Bank of England about how it assesses the impact of a reduction in the stock of asset purchases before rates reach this 0.5% level, but we understand that the requirement is for the economy to be in recovery so that quantitative tightening proceeds smoothly. Only then will the BoE continue to raise rates above 0.5% and, only at 1% bank rate, will it consider actively selling bonds.
CPI inflation for September came at 3.1% year-over-year to September 2021, 0.1% below consensus and August’s figure. Transport cost contribution to the annual CPIH (Consumer Prices Index including owner occupiers’ housing costs) inflation rate was at the highest level for almost ten years, adding 0.9% to the CPIH. The price of fuel and semiconductor shortages drove up both transport-related costs and the price of used cars, a phenomenon seen in the euro area and the US. A large negative contribution came from restaurant and hotel inflation as the “Eat Out to Help Out” scheme** base effects led to relatively higher prices in the previous month’s report.
While the latest CPI data may not be an alarm bell to the Bank of England to hike as soon as the November meeting, it is inflation on the horizon that will be concerning. From several market surveys, we see businesses no longer absorbing higher factory gate prices through compression of their profit margins. These cost-push pressures will likely be eventually passed on to the consumer, feeding into higher inflation expectations and the spiral of second round impacts. Figure 2 shows where markets see inflation heading in the near future versus the bank’s inflation forecasts.
Source: Bank of England August Monetary Policy Report, Bloomberg, Janus Henderson Investors, as at 20 October 2021.The Monetary Policy Committee (MPC) faces three other challenges before the 4 November meeting:
The Bank of England will need to assess the durability of the UK consumer and whether higher prices will spiral into broad wage growth. One thing is clear to us – that the bar for the Bank of England to underwhelm current market expectations with later, or fewer rate hikes, is low.
**Scheme ran in August 2020