UK Reaction: Policy and outlook on hold in face of delta

The Bank of England’s (BoE) Monetary Policy Committee (MPC) left policy unchanged as was widely expected after today’s meeting. Bank Rate remained at 0.1% and the Asset Purchase (QE) Facility was unchanged at £895 billion (£875 billion gilts and £20billion corporate bonds). The Committee voted unanimously to leave rates on hold, but voted 7-1 to leave QE unchanged, with external member Michael Saunders following up on a speech given in recent weeks where he suggested he would vote to end QE early. Deputy Governor Dave Ramsden, who had given a hawkish speech at the same time, did not vote to end QE early as some in markets had suggested he might. Both outcome and votes were in line with our expectations, and broadly in line with consensus market expectations.

Governor Bailey aptly remarked that there had been relatively few developments in the economic outlook since May. The BoE still considered Q2 GDP likely to rise by 5% on the quarter, although noted that it had lowered its Q3 outlook to 3% from 4%, with the impact of revived delta-COVID cases weighing on the UK and global economies. However, the BoE still looked for relatively robust growth of 2% in Q4, leaving GDP growth at 7.25% for 2021 as a whole, before slowing quickly back to trend rates across 2022 – albeit with growth in that year forecast at an upward revised 6% (from 5.75%) in 2022 and 1.5% (from 1.25%) in 2023. The minutes also described a labour market with nearly 2 million more identified as not in employment through a combination of raised unemployment, furlough and inactivity. That said, the BoE’s near-term concerns appeared to have shifted more towards one of labour market shortage – at least in the near-term – than oversupply. The BoE considered “a period” of excess demand likely, reflecting short-term supply constraints, but thought that in the medium-term supply constraint, including in the labour market, should ease, bring conditions of supply and demand back into balance across 2022 and into 2023.

Inflation has developed further. The BoE noted that June’s inflation at 2.5% was 0.8ppt higher than expected in May and that the BoE now expected inflation to peak at around 4% in Q4 2021, up from just over 3% in May. However, the Committee went into some detail to explain why they considered to expect this to be a transitory surge. First, the BoE suggested that there were already some signs of an easing in supply-side constraints. Second, that they expected demand for goods to subside relative to demand for goods, again suggesting that in the UK this process was already underway. The Bank forecast inflation to be at 2.25% in 2 years’ time and 2.10% in 3 years’ time, even if there were no policy changes over the forecast horizon. However, as the minutes noted that “all members” considered some policy tightening over the forecast horizon, the inflation forecast was 2.1% and 1.9% at 2-year and 3-year horizons assuming that rates were broadly around 0.25% in 2022 and 0.50% in 2023 – as the BoE inferred was priced by the curve. That said, Governor Bailey bridled at the suggestion of complacency in the press conference. The MPC does consider two broad sets of risks, the first reflecting any upward rise in medium-term inflation expectations – for now the Committee is satisfied that such expectations remain “well anchored”. The second the labour market developments. Here as well as the uneven pace of recovery, the BoE must add in the longer-term supply shock of Brexit and how this will reduce labour supply over the coming years.

We were not surprised by the Bank’s tone at today’s Monetary Policy Report meeting, notwithstanding some hawkish commentary from certain BoE members in recent weeks. The fact that despite a large upward revision to Q2 GDP from May’s report, that fact that expected GDP is now lower by end-Q3 than seen in May reflects our own outlook on the economy. Indeed, while acknowledging the uncertainty, we still see some downside risk to GDP growth in 2021 compared to the bank of England. We forecast UK GDP growth at 6.7% for 2021, compared to the BoE’s 7.25% and 5.7% next year, compared to 6%. However, much of this reflects an expectation of a slower rebound than the BoE, spread more into 2022, which should leave GDP growth for 2023 closer to 2% in our view. This is in part why we still consider a tightening in monetary policy as unlikely in 2022. We also expect inflation to fall back somewhat further across H2 2022 and into 2023. We see this not only as driven by the downside risks cited by the BoE of softer inflation spells following sharp increases in tradeable goods inflation, but also as we expect financial conditions to tighten from later this year, driven by shifts in global yields but exacerbated in the UK by expectations of tighter policy driving sterling firmer and the prospect of a more outsized move at the longer-end of the UK curve as markets see the BoE as relatively accelerated in its plans to reduce the balance sheet. On balance, we still see the BoE first raising Bank Rate to 0.25% around mid-2023. However, recognising Bank commentary today, we also suggest that if growth exceeds our expectations, coming in line with the BoE’s view, and/or Brexit supply capacity reductions are greater than we forecast - that the first hike could come earlier – plausibly in H2 2022, with a second 0.25% hike likely in H2 2023.

The BoE also formalised changes to its policy toolkit. Reflecting the announcement in February, the BoE had instructed PRA-regulated firms to be prepared for negative interest rates – albeit that this was not taken as a signal of delivering them. At this meeting, the BoE reported that banks were prepared for negative rates, with or without a tiered system for reserves remuneration. The BoE went further today in adjusting the expected process it would follow when it comes to tightening monetary policy – the sequencing. The BoE changed its former commitment that it would not begin to reverse its QE holdings until Bank Rate had reached 1.5%, now stating that after 0.5% the Bank would begin to end re-investments and after 1.0% it would consider active sales – both subject to broader economic circumstances at the time and both in transparent and predictable manners. This change reflected two views. The first that the Bank believed that the impact of QE unwind would be less than of QE purchases (in turn both a signalling effect and a result of purchases operating in disrupted markets). The second that the BoE still identified changes in Bank Rate as the primary policy tool, but that in creating space for negative rates, the effective lower bounds (ELB) had been lowered to create more space for reduction even from the lower 0.5% rate. Governor Bailey refused to answer a question on whether the 100bps lowering of the QE unwind ceiling could be interpreted to suggest that the Bank’s estimate of the ELB had also lowered by 100bps, that is to suggest that the Bank now considered it could lower rates to -0.90% if necessary.

Our reaction to this is two-fold. First pragmatically, with the Bank suggesting that it would first end reinvestment the likely scale of impact on the market would be small. Around £70bn of assets would mature over 2022-23 (£130bn 2024-25), suggesting a pace of unwind around one quarter the pace of easing from November 2020. Moreover, we would also expect the impact of an unwind to be less than asset purchases, although not negligible. Hence the total impact of an unwind would likely be relatively small. However, we are not convinced by the need of such a change, at least as stated. First BoE QE holdings do not appear excessive compared to other central banks, being on a par with the Federal Reserve and lower than the ECB and Bank of Japan. The Bank still appeared to have abundant QE policy space, but this does not look the case for conventional policy space. While balance sheet reduction would be small, it would still add to an overall tightening and reduce, if not remove, the need for further rate hikes, adding to resistance in raising policy rates above 0.5% compared to before – not least risking exacerbating longer-term yield curve moves with short term moves. While the BoE may still have the same scope to reduce rates, this would now include a move into negative territory – which is not without controversy, with many still considering the benefits of moves further into negative territory to be less stimulative than positive rate cuts. With the net benefits of negative rates still debated, this should add to pressures to raise the policy rate above 0.5% relative to not having made the change – not least risking exacerbating longer-term yield curve moves with short term moves. On balance, at the margin we argue that this needlessly reduces the BoE’s monetary policy flexibility, although we also note that the BoE intends to review these processes. Finally, however, we note that the Treasury is a beneficiary of this change, as this should limit the amount that HMT needs to transfer back to the BoE to remunerate interest on excess reserves should policy rates rise, relative to that which is has transferred from the BoE from the QE process.    

Market reaction to today’s announcements were mixed. Interest rate markets reacted hawkishly, the short-sterling strip rising sharply to suggest a Bank Rate hike to 0.50% was fully priced by Q1 2023. Longer-term rates rose more gradually, but both 2-year and 10-year gilt yields rose by 2bps after the announcement to 0.09% and 0.53% respectively. Sterling however, which had drifted higher ahead of the announcement, softened by 0.1% against both the dollar and the euro to £1.391 and £0.851 respectively.