UK Reaction: Bank of England turns to larger-than-expected hike as inflation expectations rise
- The Monetary Policy Committee (MPC) hiked Bank Rate by 50 basis points (bp) to 5%, by 7 votes to 2 (voting for rates to remain unchanged), above our own and market consensus expectations of a 25bp hike.
- The scale of the upside surprises in recent wage and inflation data, and the recent uptick in market inflation expectations saw the Bank of England (BoE) step up its pace of hiking unexpectedly.
- We continue to expect the BoE to hike by 0.25% at its next meeting in August and think this will prove to be a peak.
- Risks to our call remain skewed to the upside. We expect an easing in core inflation and wages to allow the BoE to pause in September, but continued signs of labour market tightness and domestic inflationary pressures could see an additional hike in September.
The BoE's MPC raised Bank Rate by 0.5% to 5% above our own and consensus market expectations of a 0.25% hike. We had suspected that some amongst the committee would support a 50bp hike, but the actual vote split was more united on the face of it, with 7 members voting for a 50bp hike and 2, Swati Dhingra and Silvana Tenreyro, continuing to vote to leave rates unchanged. This marks Tenreyro's last meeting as a member of the MPC. Megan Greene will replace Tenreyro at the MPC’s next meeting in August, which is likely to reduce the balance of doves on the committee.
Despite the increase in the pace of hiking, the MPC maintained its previous guidance indicating that they would "monitor closely indicators of persistent inflationary pressures" which includes labour market tightness, wage growth and services inflation, leaving the door firmly open for future hikes. In recent months the data has consistently surprised to the upside, importantly in key measures of inflation persistence that the BoE had indicated they were monitoring. In yesterday's May consumer price index (CPI) release, services CPI had risen to 7.4%, 0.5 percentage points (ppt) above the BoE's May forecasts and in the April Labour Force Survey data. Annual growth in regular Average Weekly Earnings had risen by 7.6%, 0.5ppt above expectations in the May report. The members who voted in favour of the hike judged that the scale of the upside surprises suggested a 0.5% hike was "required". Interestingly, the BoE also referenced the increased sensitivity of markets to economic data releases, which is of little surprise to us considering the increased focus the BoE itself has placed on these measures.
The BoE's credibility and ability to manage the inflation problem the UK faces has been called into question as of late; the signs of stickiness in UK inflation and continued tightness of the labour market has kept these discussions alive. This has been coupled with a further increase in medium-term inflation compensations measures In financial markets. We see the increase in the pace of hiking as an attempt to address any rise in medium-term inflation inflation expectations.
In recent weeks, as two-year fixed mortgage rates have topped 6%, discussion of the looming mortgage impact (more technically part of the long and variable lags of monetary policy) facing the UK economy as many households refix mortgages at significantly higher rates has grown. Changes in the structure of the mortgage market (longer average length of mortgage fixes) mean that the pass through of rates to mortgages has slowed when compared to previous cycles, and have contributed to the relative strength of the economy. But we see the impact accelerating over the next few quarters as many more households with mortgages and renters face rising housing costs, and we think the view of the doves on the committees will come into focus with their assessment that "sizeable impacts from past rate increases were still to come through". As Bank Rate creeps higher, we see a growing risk of recession as the eventual mortgage impact accumulates in the economy and whilst there has been some discussion of how homeownership has been on a gradual decline, with many buy-to-let landlords also facing the squeeze, many renters will also be impacted. And just as rate hikes have been slow to pass through, we are mindful that rate cuts will also likely be slow to pass through to the economy when the Bank is ready to ease policy – something we expect to begin next year.
We expect the MPC to hike Bank Rate by 25bp at its next meeting on 3 August, bringing Bank Rate to 5.25%. We think this will prove to be a peak. By the time we come around to September, we judge that an easing in core inflation and clear slowing in employment will allow the BoE to pause its hiking cycle. However, we continue to see the risks firmly skewed to the upside and as ever, the labour market and inflation data remain crucial. We think that continued signs of labour market tightness and elevated domestic inflationary pressures could see the BoE hike again in September.
The market's reaction to the larger-than-expected hike by the BoE was mixed. Gilts rallied following the announcement, 10 year gilts yields fell by 12bp and have since moved to around 4.378% and 2-year gilt yields have flip-flopped and are currently slightly above levels prior to the hike at 5.057%. Sterling has held steady against the euro and the dollar following the rate hike decision as FX markets anticipate the negative pressure rising rates will place on the economy. Markets now see the chance of a 25bp rise at its next meeting in August at 66% and the expected end-year rate has risen by 18bp after today’s meeting, suggesting a peak around 6%.