The Bank of England (BoE) has gone against consensus expectations by raising its main policy interest rates by half a percentage point in their June meeting. The decision to re-accelerate the pace of hikes follows stronger-than-expected labour market and inflation figures, further casting doubt over the effectiveness of monetary policy.
This is the 13th consecutive interest rate rise for the UK, taking the main policy interest rate to 5% - its highest level since September 2008. The vote amongst the Monetary Policy Committee (MPC) showed that seven of the nine members backed the half a percentage point rise, but two members dissented, voting for no change. It is worth noting that Silvana Tenreyro, one of the two doves on the MPC, will end her term this month, potentially at the margin shifting the bias for further rises going forward.
Ahead of the meeting, although the majority of economists (including ourselves) had forecast a smaller quarter point hike, options markets suggested a 48% chance of the larger increase. Investors also had interest rates rising and peaking at 6% by the first quarter of 2024. Since the Bank’s announcement, there is now approximately a 50% chance implied by options markets that peak will reach 6.25% by the end of this year (three months earlier).
Recent data suggests inflation to remain high
Two sets of key data have clearly panicked the MPC. The first is the latest set of labour market statistics (published 13 June) which showed another fall in the headline unemployment rate (to 3.8%), with a surprise acceleration in wage growth excluding bonuses (up to 7.2% y/y). More concerning from an inflation perspective is that a previously reported large decline in employment reported by the experimental HMRC (tax authorities) data was revised back to being positive. Tentative signs of a slowing labour market have been revised away, suggesting further inflation pressures are set to build.
The second was the inflation data published yesterday (21 June) that showed headline CPI inflation stuck at 8.7% y/y versus consensus expectations of a fall to 8.4%. Although energy inflation, which has been the main source of the rise in the cost of living continued to fall back, core inflation (excluding energy, food, alcohol and tobacco) accelerated from 6.8% to 7.1% y/y. Services inflation, which is dominated by the cost of labour, rose to 7.4% y/y – its highest annual rate since March 1992. Although exceptionally high, delving within the details reveals that excluding volatile transport services inflation, the remaining “core services” inflation actually fell slightly. It appears that inflation in aviation fares was to blame, with an amazing 20% rise month-on-month recorded in May. This may be linked to the additional bank holidays which shifted travel plans. If so, we should see a reversal next month.
Why higher rates haven’t yet worked
As we have flagged previously, BoE data shows that the share of households in England with outstanding mortgages has fallen over the past decade from 32% to 26%, reflecting the ageing population of the UK. Moreover, data on the distribution of mortgages shows that the share mortgages on a floating rate has fallen from 71% in 2012 to just 13% in December 2022. UK households have taken advantage of very low interest rates and increased fixed-term mortgage products to reduce their near-term exposure. The share of households with a fixed-rate mortgage of two years or more has risen from 16% to 63% over the same period. This means that when combining the sets of data, only about 9.7% of households will see interest rates impacting their mortgages before the end of 2024.
Granted, those renting accommodation will be impacted indirectly, and experimental data from the Office for National Statistics released yesterday (21 June) showed rents are accelerating. Rents, however, have on average risen by just under 5% y/y for the UK – far less than the increases being felt by those that are forced to re-mortgage at present.
Market reaction suggests rising recession fears…
The market reaction has been interesting since the announcement. The re-pricing of interest rate expectations has led to the 2-year gilt to sell-off (higher yield), but the 5-year and 10-year gilts have moved in the opposite direction (yields falling). Moreover, sterling is slightly down versus the US dollar and euro. This is unusual for a larger-than-expected interest rate hike, and can only be explained by rising fears of a recession.
… as wider risks to financial stability are increasing
Our analysis suggests that the aforementioned developments in the housing market have made the household sector less sensitive to rising interest rates and contributed to the UK’s inflation problem. Brexit effects have also made the UK more inflation prone, through their impact on imports and the ability of companies to source the required staff.
As also previously stated, we would need to see a fundamental change in behaviours in order to lower inflation in a timely manner. This would require a shift from spending to saving, which ultimately needs much higher interest rates, potentially as high as 7-8%.
However, we have also said previously that we did not believe the BoE would go that far as it could lead to major financial stability risks. Very high interest rates are likely to make the current housing market even more unaffordable that it is, forcing prices down sharply. While banks are better prepared for such a correction in prices, excessive falls would likely require capital raisings. If banks struggle to do this in the usual way, then a banking crisis could ensue, requiring the government to step in with bail-outs. It could quickly become a self-fulfilling prophecy.
Concerns over the gilt market remain following last year’s disastrous flirtation with huge fiscal stimulus from the Truss government. The UK government is paying a higher interest rate to lenders (through gilts) compared to its peers partly due to the higher risk attached to the UK’s finances. If investors start to fear that the government may need to bail-out some banks, then there could be a run on gilts, and sterling could fall sharply in response.
However, today’s larger hike is calling into question our forecast. The BoE recently admitted that its forecasts have not been performing well enough, and an external review of its processes may follow. It suggest that the MPC is no longer placing much emphasis on its analysis, and instead being forced to raise interest rates until the macroeconomic data worsens. Given that interest rates work with a significant lag, lengthened by developments in the mortgage market, it may mean that the MPC can no longer wait and allow inflation to fall back more gradually.
This raises the risk of not only a recession, but a far more dangerous scenario. The BoE’s next Financial Stability Report (FSR) will be published on 12 July and will be crucial in deciding how higher interest rates can rise. If the FSR starts to flag stability risks, then the MPC must take note and factor this into their plans. However, if a clean bill of health is reported back, then this gives the MPC the runway it needs to raise rates to 6% as the market has priced, or even beyond.