UK Reaction: BoE holds steady as labour market puzzle unfolds

The Bank of England (BoE) left monetary policy unchanged today with Bank Rate at 0.1% and the APF target at £895bn (£875bn gilts, £20bn corporate bonds). This was as expected, however, Deputy Governor Dave Ramsden joined external member Michael Saunders in voting to tighten monetary policy by stopping the asset purchase programme at £840bn in gilts.

The Bank’s review of current economic developments included a second successive 1ppt downward revision to its Q3 GDP outlook. This now stands in line with our own 2% (quarter-on-quarter) forecast, although we consider risks skewed to the downside to our outlook. There was no update as to whether the BoE expects this growth to re-emerge in subsequent quarters, but we suggest it should lead to a lowering of the 2021 growth outlook from its current 7.25%. Our own outlook is for 6.6%.

Minutes described the outlook for CPI inflation, which the BoE now warned was likely to slightly exceed 4% in Q4 2021. As well as the aforementioned supply bottlenecks, the BoE noted rising wholesale gas prices as an additional upside risk to the price outlook. However, the minutes reiterated that they still expected the inflation spike to be transitory and that there were “good reasons to expect a material supply response in commodity and other global goods markets”. They suggested that the medium-term outlook was still that the inflation shock would remain “transitory” and return to close to 2% over the medium-term. The minutes also made clear that monetary policy should only respond to “medium-term” price pressures and not to “transient” developments. The minutes considered whether the current price spike would push inflation expectations higher - an upside risk. Minutes reviewed a range of longer-term inflation expectation, recording that these had increased, but broadly to 2013 or longer-term historic average levels. The minutes concluded that inflation expectations “remained well anchored”, but that the Committee would continue to “monitor very closely” future developments.

In the context of longer-term drivers of inflation, the MPC focused on the labour market – also the area causing the most uncertainty. Short-term developments pointed to a tight labour market with unemployment falling to 4.6% in the latest report, vacancies elevated and reports of hiring difficulties rising. At the same time the numbers of workers remaining on furlough had reduced, but by a “materially lesser degree” than the Committee had expected, with an estimated 6% of private sector jobs still on furlough in early September – some sectors seeing high vacancies and high recorded furloughed workers at the same time. The MPC considered a number of explanations for this discrepancies, including more structural mismatches. The Committee concluded that the outlook for the labour market was “particularly uncertain” for now, but that much of that uncertainty may be resolved over the coming months. An accurate understanding of how tight the labour market would remain over the coming years is critical to understanding the UK’s longer-term inflation outlook, particularly as Bank staff now estimate underlying pay growth to have exceeded pre-pandemic levels. A more substantial review of this is likely in next month’s Monetary Policy Report (MPM), particularly as this will include a broader review of supply conditions.

In terms of the monetary policy outlook, it was no surprise to see policy unchanged today, but Dave Ramsden’s vote to tighten policy adds to market expectations that the MPC could raise interest rates in H1 2022. However, November’s MPM will be interesting in assessing to what extent the BoE’s persistent growth optimism is fading. Moreover, the evolution of the labour market over the coming quarters will be critical. We do envisage some increase in unemployment as furlough ceases and some alleviation of labour supply shortages as “normal” live resumes into Autumn, despite the ongoing risks from COVID. That being the case we fully expect inflation to fall back materially in H2 2022 and the BoE to largely look through the current inflation spike. However, at the same time demographic effects and post-Brexit migration trends do seem to have left the UK with a less benign labour supply. We also add that the MPC does appear to be more hawkish in tone, above and beyond the broad acceptance that there was a need for “some modest tightening of monetary policy over the forecast horizon”. As such, we adjust our own Bank rate forecast to consider the first increase in Bank Rate (+15bps to 0.25%) to H2 2022 – at this stage considering August as most likely – and add a further hike expectation (+25bps) to 0.50% for May 2023. At this point conditions for the cessation of QE reinvestment would have been met and this should result in a more general tightening in financial conditions over and above a usual +0.25% Bank Rate increase. However, we also recognise that if we are wrong and the UK labour market is suffering a more critical structural adjustment, the Bank may be forced to bring rate hikes sooner and faster than we currently consider.     

Financial markets reacted to today’s release as a confirmation of hawkish intent. 2-year gilt yields rose by 7bps to 0.35%, with the short-sterling strip also rising 7bps across 2022 and 2023. 10-yr gilts also rose by a sharp 5bps to 0.85%. Meanwhile sterling rose by 0.2% against both the Euro (£0.855) and the dollar ($1.37), undoing some of its recent softness to the latter.