UK Reaction: BoE provides hawkish surprise in "a forecast of two halves"

David Page, Head of Macro Research at AXA Investment Managers, comments on the latest Bank of England monetary policy meeting:

• The BoE raised Bank Rate by 0.25% to 0.5% the first back-to-back hike since 2004.
• Four members of the Committee voted for a 50bps increase.
• The BoE endorsed that this would begin a passive unwind of the gilt portfolio, starting with a £28bn maturity next month.
• And it announced a full unwind of its £20bn corporate bond holding, although it suggested that the impact would be very small.
• The hike reflected revised expectations that inflation would peak at 7.25% and that the labour market was very tight.
• However, in exacerbating the squeeze on household incomes, the BoE forecasts GDP slowing to 1.25% next year and 1% in 2024, unemployment rising to 5% and inflation falling to 1.6% at the end of the forecast horizon on a central forecast and possible to 1.2% by next year.
• We expect the BoE to continue with near term tightening, forecasting +0.25% hikes in May and August. But for now, we do not expect market expectation of 1.5% by end year to materialise.   

The Bank of England surprised markets today with a more hawkish announcement than expected – confounding our own expectations that there was a chance that the MPC might not tighten rates. The BoE raised Bank rate by 0.25% to 0.50% - following December’s 10bps rise – making this the first back-to-back rate hike since 2004. However, the surprise was that four members (Haskel, Ramsden, Saunders and Mann) voted for a 0.50% rise. Having raised rates to 0.50%, the Bank approved the beginning of a passive unwind of its balance sheet. This opens the door to a £28bn maturity next month – significant in representing around one-third of the total reinvestment due over the coming two years. The Bank also announced not only the passive unwind, but an active sell off of its £20bn corporate bond portfolio, something that the Bank stressed would likely only have a “very small” impact on monetary conditions and should in no way be seen as a signal of future intention for the gilt portfolio. 

Governor Bailey made the prima facie case for policy tightening. The rise in energy and goods prices had led the Bank to revise its expectations for the peak in inflation to 7.25% in April – nearly 2ppt higher than in November. At the same time the Governor said that GDP had closed 2021 with strong momentum and the impact of Omicron was expected to be relatively minor, albeit that it might leave Q1 GDP growth around flat. Further, the labour market was described as very tight and Bank forecasts envisage unemployment easing below 4% over the coming months. The Governor explained that the impact of the cost of living squeeze was the produce of an adverse terms of trade adjustment of which there was little that monetary policy could alleviate. The BoE statement concluded that it was for monetary policy to ensure that a “real economic adjustment occurred”. Indeed, the minutes went further to explain that those MPC members voting for a 0.50% hike were intent on delivering an even stronger message to prevent the risk of inflation expectations – already rising in the short-term – from loosening over the longer-term from the current “well anchored” position. 

However, Governor Bailey explained that this was also a forecast “of two halves”. Indeed, with monetary policy now adding to the squeeze on household incomes – already forecast to be amongst the largest of the last three decades, the outlook for the economy looks set to turn. Based on the rates implied by markets (broadly rising by a further 100bps to 1.50% by mid-2023), the BoE forecast that UK GDP growth would slow to 1¼% in 2023 and 1% in 2024. This “subdued” rate of growth was expected to see excess supply emerge from the end of this year and grow. This excess supply was broadly driven by the labour market and the BoE forecasts in this scenario unemployment to rise from below 4% to 5.0% in three years’ time. And all of this weighs on the inflation outlook, which in the central scenario falls below target in two years’ time and ends the forecast horizon at 1.60%. This even with the BoE’s assumption convention of seeing energy follow futures prices for 6 months and assuming constant prices thereafter. Replacing this assumption with one that energy follows the path of future prices over the coming years, the MPC forecast inflation falling to 1.2% next year and staying there through 2024. Indeed, on this alternative scenario, if the BoE didn’t hike again from today inflation would drop to around 1.7% next year and stay there in 2024. 

Governor Bailey emphasised elevated uncertainty at present and in revising our own outlook for BoE policy rates, we follow the advice of Fed Chair Powell who said the Fed would have to be “humble and nimble”. Before today, we had forecast Bank Rate rising twice this year (May and Nov) and one next. The BoE is clearly less confident on how well-anchored inflation expectations will prove and hence has moved more quickly. We thus suggest that with near-term risks likely tilted towards the upside over the coming months the BoE is likely to hike again to 0.75% in May (with an outside chance of March), and once again in August (to 1.00%). This would appear consistent with the Bank’s statement that if the economy evolved broadly in line with February’s projections “some modest further tightening was likely appropriate over the coming months”. Yet we note that if a benign scenario with regards Russia-Ukraine and COVID materialises, the Bank may not need to tighten in August. This would be important as the move to 1.00% is the point at which the BoE has stated that it would consider active sales of the gilt portfolio. However, if as has been the case, further supply shocks materialise over the coming months driving inflation higher, the Bank may need to raise rates further.           

Financial markets reacted to the hawkishness of today’s actions. 2-year gilt yields rose 12bps to 1.14%, with 10-year yields rising 8bps to 1.36%. The market strip expect the BoE to hike rates by 25bps per meeting until June and to leave rates at 1.50% by end-2022. And sterling rose by 0.2% to the USD. We argue that this reaction focuses totally on the near-term aspects of the BoE’s forecasts and reflects its current sensitivity to further inflation surprises. However, it does not recognise the sharp slowdown the BoE envisages for the economy and the rise in unemployment that the BoE thinks such a course of rate hikes would deliver. Or maybe, for now, it simply does not believe the BoE outlook.