At its March meeting, the Bank of England’s (BoE) Monetary Policy Committee raised the policy rate from 0.50% back to its pre-pandemic level of 0.75%. While this matched consensus expectations, an 8-1 split vote was a dovish surprise for markets.
Most of the committee judged that a rate hike was appropriate to prevent pay trends and inflation becoming embedded. However, Sir Jon Cunliffe objected owing to the “very material negative impacts of higher commodity prices”.
The committee has now hiked rates at three successive meetings, a feat only previously accomplished when it was first convened in 1997. This underscores the scale of the current concerns about inflation, which at 5.5% in January is more than double the committee’s 2% target.
Looking ahead, inflation is set to climb further as the relentless rise in wholesale energy prices is passed on to consumers. Policymakers now expect it to reach 8% in Q2, a rate unseen since the early 1990s. It could peak at an even higher level at the next fixing of the Ofgem price cap in October if the recent rise in energy futures is sustained.
There is also considerable tightness in the labour market that raises the risk of “second round” effects. The vacancy-to-unemployment ratio now stands at the highest level since records began in 2001 even as the unemployment rate has fallen below 4%. Underlying pay growth is resultantly running at around 4-4.5% compared with 3-3.5% before the pandemic and could pick up further.
These factors point to further rate rises. Today’s hike came sooner than we expected and it seems clear that rates will rise further in the near term. However, we think there are at least three reasons to think that market pricing for Bank Rate to climb to around 2% at the turn of the year is overdone.
First, unless the Chancellor caves in to pressure to loosen the purse strings at next week’s Spring Statement, fiscal policy will tighten as pandemic-related spending is reined in and National Insurance contributions are hiked. Second, while much depends on how the conflict in Ukraine develops, higher energy costs will choke off consumer demand and weigh on growth. Third, inflation is set to fall sharply in 2023 as energy prices moderate from elevated levels.
The upshot is that while we expect the committee to raise rates on a further two occasions to 1.25% in the coming months, we then expect a pause as policymakers assess the impact of higher rates on the economy. Thereafter, the hiking cycle is only likely to resume when inflation heads back towards target. We believe this is unlikely to occur before 2024.