Omicron to delay UK rate rise

The Bank of England’s (BoE) monetary policy committee (MPC) will meet on Thursday to decide whether or not to change its policy stance. The BoE surprised many by not raising rates at the November meeting, and with inflation remaining elevated, attention will be keenly focused. Key policy meetings also take place in the US and Europe this week.

At the end of last month, we changed our forecast for UK interest rates, bringing the first rate rise forward to this month, and adding a further rise for February 2022. However, the arrival of the Omicron variant of Covid-19 has prompted the re-introduction of some soft restrictions, but has the potential to cause more disruption. We think this may be enough to persuade the BoE to postpone that first rate rise to February.

Labour market strong, inflation still high

Today’s labour market statistics release further highlighted the strength in hiring, and the building of inflationary pressures. The unemployment rate, which is a three-month average to October, fell to 4.2% compared to 4.6% in the previous three months. Moreover, the release suggests that there was little impact from the end of the government’s furlough scheme at the end of September. The monthly data did show a rise in unemployment, but the typically used three-month average continues to trend downwards.

Although wage growth for the whole economy moderated in the three months to October, it remains elevated at 4.9% compared to the same three months a year earlier. The furlough scheme has distorted these figures, but the latest reading is higher than consensus forecasts of 4.6% growth.

The next inflation release (tomorrow) is likely to show headline consumer price inflation (CPI) rising to over 4.5% - well above the BoE’s upper target of 3%. Much of this is caused by rising wholesale energy prices, and in our forecast, we have CPI rising to above 5.5% by April 2022, before it falls back.

The risk for the economy is with higher inflation (even if temporary). A tight labour market may lead to much higher wage growth, which in turn could prompt companies to raise prices further.

To the downside, however, GDP growth disappointed consensus expectations last week as economic activity grew by just 0.1% in October, compared to 0.6% in September. Accommodation and food services were one of the biggest drags, which is only likely to worsen now that the government has re-introduced its “work from home” order. The festive period is the most important for the sector, and so the return of such rules will come as a blow. Real-time data from Opentable.com is already showing a fall-off in restaurant reservations.

Downside risks

Compared to the start of the year, restrictions remain light, but at the same time, there are less support measures in place. The furlough scheme has expired, along with various tax bill deferrals. This means that the impact of restrictions in reaction to Omicron so far are likely to be less widespread. But the lost business for those firms that are affected is likely to have a larger impact on their finances, and likelihood of survival.

The UK government is trying to minimise economic restrictions, focusing on accelerating its Covid booster programme to build immunity. However, case numbers are climbing, which could put the national health service under severe pressure, and potentially force another lockdown in the new year.

The BoE faced criticism for suggesting that a rate rise was imminent, but then keeping policy unchanged in November. However, the risks have now shifted to the downside. The BoE has to weigh the risk of higher inflation, which it could correct at a later point with its tools, against the risk of deflationary forces arising from another lockdown if Omicron is judged to be severe.

It is worth remembering that the BoE’s quantitative easing programme is due to end this month, and so there is a form of monetary tightening already taking place. The BoE currently has far greater scope to tighten policy rather than to loosen it. As such, we think the BoE may opt to err on the side of caution, and keep interest rates on hold this month, and perhaps hike in February instead. Of course, only if further lockdowns are avoided.