UK Reaction: BoE lifts Bank Rate - focuses on inflationary consequences of Omicron
David Page, Head of Macro Research at AXA Investment Managers, comments on the Bank of England’s decision to raise interest rates:
- The BoE hiked rates by 0.15% to 0.25%, the first hike since 2018. Silvano Tenreyro was the only member of the Committee to oppose the move. QE was left unchanged by unanimous vote.
- The rise was in line with our forecast, but against the consensus view (Bloomberg recorded 8-34 for hike versus hold) and market expectations.
- The case for a hike was clear with inflation elevated and rising more than expected; and a tight labour market with signs of rising pay pressure and second round inflation effects.
- The uncertainty came from the omicron variant, and created a “finely balanced” decision, but the BoE argued that while uncertain, omicron posed downward risks to activity, but a more uncertain outlook for inflation.
- Future rate hikes will depend on the evolution of the virus. For now we continue to expect two hikes in 2022 (May and November) and one in 2023 (November), but acknowledge elevated uncertainty.
The Bank of England’s Monetary Policy Committee (MPC) increased Bank Rate by 0.15% to 0.25% - the first rate hike since mid-2018 and the first tightening in policy since the pandemic. The hike was in line with our expectation, but against the consensus view (Bloomberg cited only 8 of 42 economists expecting a move today). The MPC acknowledged that this was a “finely balanced” decision and indeed the Committee voted 8-1 to hike, with Silvano Tenreyro voting to leave policy unchanged and await further information in February. Otherwise the Committee was unanimous to leave QE targets unchanged.
The case for a rate hike had been clearly established. The MPC reiterated the “primacy of price stability in the UK monetary policy framework”. Indeed, the Committee stated that inflation had come in 0.6ppt higher than expected in last month’s Monetary Policy Report and that it now expected inflation to peak at around 6% in Q2 2022 as the next increase in domestic utility bills was passed on. Beyond that, the MPC still expects inflation to fall quickly back towards target. However, the tightness of the labour market had led the Committee to consider “upside risks to pay”, with Bank staff estimating that underlying pay growth was rising more quickly than before the pandemic citing survey evidence, including the RECS survey, where the permanent staff salaries index was at an all-time high. In November, the MPC had stated that it had withheld policy tightening to await evidence on the labour market after the furlough scheme had closed. This evidence showed no untoward developments and today’s minutes made the case that unemployment could fall further as the labour market attempted to match unfilled vacancies.
What made today’s decision more uncertain was the emergence of the omicron variant. The Committee acknowledged significant uncertainty remaining around the characteristics of this new strain, but that best estimates suggested that it “poses new risks to public health”. The Committee also acknowledged that this could weigh on activity. However, it made two further observations. First, that successive waves of COVID had had less disruptive impacts on the economy – although it acknowledged that this might not be the case this time. More pertinently, minutes explained that while risks to the growth outlook were to the downside, this was not necessarily the case for inflation. It concluded that the outlook for inflation if omicron ended up being another material challenge were uncertain – a weaker demand outlook would dampen the inflation outlook, but unknown supply considerations – including from international supply chains – could exacerbate inflation pressure. This would be particularly so if demand remained focused on goods and tradeables as had been characteristic of the pandemic so far. In short, omicron may pose a significant downside risk to growth, but not necessarily to inflation – a classic supply shock. Against a background of severely elevated inflation the BoE concluded that there was a “strong case” to tighten policy modestly now.
The Committee noted that it would review developments at its February Monetary Report Meeting. It stated that the path of future policy would depend in part on the evolution of the virus. However, it described “two-sided” risks to the outlook and suggested that further modest tightening “is likely to be necessary”. The evolution of the virus does make the medium-term outlook more uncertain. Our central assumption is that the UK will face further restrictions in early 2022 which will dampen activity. However, our hope is that a combination of restrictions and further vaccination will make any such period relatively short. If this proves the case, the economy could be rebounding again in Q2 – and would likely face the additional supply challenges that omicron could bring. As such, we expect the MPC to continue to tighten. We forecast the MPC raising rates again in May (to 0.50%). This would then initiate a passive unwind of the BoE’s asset holdings, although with only small redemptions due over Q3 the impact of this would be modest this year. We also expect a further hike (to 0.75%) in November. Thereafter, we expect inflation to be visibly falling back towards target. For now we pencil in just one hike in 2023 to 1.00%, which we forecast one year later in November.
Markets reacted as expected after a hawkish surprise. Yields rose on 2-year and 10-year gilts by 10bps and 9bps respectively (to 0.57% and 0.82%), although both remain materially lower than levels at the start of November. Sterling gained by 0.6% against the US dollar, to $1.335, and although it rose initially by 0.6% to the euro, the subsequent ECB announcement saw some catch-up in the euro: sterling is currently 0.25% firmer to the euro at £0.848. The FTSE 100 equity index dropped 0.25% on the announcement.