UK Reaction: BoE policy unchanged, but stance is more balanced/hawkish

David Page, Head of Macro Research at AXA Investment Managers, comments on the latest developments from the Bank of England (BoE):

• The BoE left Bank Rate and its QE targets unchanged in May.
• Chief Economist Haldane voted to reduce the QE gilt purchase by £50bn and the BoE announced that it would slow the weekly pace of purchases, although stressed this was not a shift in the policy stance.
• The BoE also changed the wording in its forward guidance, rebalancing the previous downside skew to its outlook for future policy changes.
• The BoE revised up its GDP outlook to 7.25% (from 5%) for this year, with a 3ppt increase in its outlook for Q1.
• Inflation was also forecast to overshoot the target to around 2.5% later this year – now more in line with our view - before returning to modestly below target over the medium-term.
• We believe that the BoE’s GDP forecast is optimistic for this year – but acknowledge severe uncertainty. As such we forecast modestly higher unemployment and lower inflation than the BoE for next year.
• We forecast the BoE to begin tightening policy only in H2 2023, modestly later than current market forecasts and envisage sterling taking some of the strain if rate expectations rise much from here.

The Bank of England announced its latest decisions and Monetary Policy Report. It left policy unchanged, with Bank Rate left at 0.1%, the gilt asset purchase target unchanged at £875bn and the corporate bond purchase target unchanged at £20bn, all as widely expected. The policy rate and corporate bond target decisions were by unanimous decision, but BoE Chief Economist Andy Haldane voted to reduce the stock of gilt purchases by £50bn. The implications of Haldane’s vote are reduced by the recent surprise announcement that he will leave the Bank in June – the BoE is actively recruiting a successor. The BoE additionally announced that it would reduce the pace of asset purchases. When it extended its QE programme by £150bn in November, the Bank stated this was expected to see purchases through to end-2021, a target reiterated today, but that this would include a tapering of purchases over the period. Our estimates suggest that the pace of purchases would fall from the £4.4bn/week they have broadly maintained since last August to around £2.5bn if they are to remain constant for the remainder of the period. Minutes to today’s decisions explained that with the stock of purchases unchanged, this did not constitute a change in the stance of policy. However, this is a reduction in the pace of purchases at a time that the Federal Reserve believes that it is “too early to start talking about talking about tapering” and the ECB has increased the pace of purchases. Finally, the MPC adjusted the language of its guidance replacing downside skew to March’s guidance that it “stood ready to take whatever additional action” to that “it will take whatever action” to achieve its remit – a more two-way assessment.  

Today’s decisions were backed by the updated medium term forecasts in the Monetary Policy Report. The BoE materially revised up its GDP outlook. It now projects GDP to rise this year by 7.25% (from 5% in February), by 5.75% (7.25%) in 2022 and 1.25% (unchanged) in 2023. The bulk of this revision comes from a 3ppt increase to the outlook for GDP in Q1 this year to -1.6% from -4.2% in February. This change comes to a large part from better than expected outcomes and upward revisions to preliminary GDP data from January and February. We have a lot of sympathy with this and our own outlook has swung to -1.75% from -3.5%. Looking further ahead, the BoE still assumes a large 4.3% rise in Q2 (somewhat softer than the 5.2% it forecast in February) with a robust 3.9% and 2.0% pencilled in for Q3 and Q4. It forecasts he level of GDP returning to the pre-Covid level by end-2021. The BoE noted that global growth had generally held up better than expected and would support UK GDP more; that measures from Budget 2021 – particularly the investment super-deduction – would boost business investment. But the Bank also stated that it had changed its assumption of how much excess saving would be spent by UK households, doubling its estimate to 10% from 5% in February and that it now expected less permanent output loss. The Bank characterised risks skewed to the downside for this year, related to Covid, but broadly balanced thereafter.

The Bank also increased its inflation outlook. It now forecasts a near-term overshoot in the CPI to peak at around 2.5% in Q4 of this year (in February it saw this remaining around 2.1% and it is now more in line with our own forecast) – before settling back to just below 2% over the medium-term. Governor Bailey specifically referred in his press conference to the “transitory” nature of this expected overshoot, driven as he suggested to a large part by energy-base effects and tax changes. Looking further over the forecast horizon the settling of inflation back to slightly below target is based on both an upward revision to the outlook for sterling (of around 3%) and a rise in the implied market rate assessment, of around 30bps from February (the BoE now infers Bank Rate at 0.20% in 2022 and 0.40% in 2023). Despite this shift, the BoE still basically considers inflation around target – although we note that the Bank projects a modest overshoot over the medium term (to 2.10%) if Bank Rate remains unchanged at 0.10%, providing some endorsement for the tightening profile currently priced by markets. The BoE considered the balance of risks to inflation to be broadly balanced.

We concur with the BoE’s assessment that much uncertainty still surrounds the outlook for UK activity. The BoE’s outlook for Q2 GDP growth – though softened to 4.3% from 5.2% - marks a substantial change in view given the much shallower drop in activity now expected in Q2. We have been consistently surprised to the upside by recent developments in GDP and consider some upside risk to our own Q2 estimate of 2.5%, but 4.3% would be a sharp rise. We hold broadly the same forecasts for H2 2021 at 4.0% and 1.8% for Q3 and Q4. However, in the context of an expected softer Q2, these are more modest overall and reflect some caution in our forecasts that virus cases may accelerate again after the removal of restrictions – albeit maybe not until Q4 – and that this would likely trigger some precautionary behaviour. In essence we include some of the downside risks the BoE flags in our baseline assumption. As such, we forecast GDP growth slower in 2021, but correspondingly firmer growth in 2022 and we forecast the UK regaining pre-Covid levels only in 2022. Accordingly, we forecast unemployment still a little firmer than the BoE post-the furlough scheme, estimating it at just under 6% in Q4, compared with the BoE’s under 5.5%. We also expect inflation to average a little lower at 1.7% across 2022, compared to the BoE’s 2.2% forecast. In terms of policy, noting that the BoE does not provide a policy rate projection, we would suggest that markets currently suggest a first rate hike to 0.25% in May 2023 and around a 70% chance of a further hike to 0.50% by year-end. To our minds, this is a little aggressive and our own forecast is for a rise in Bank Rate to 0.25% in August 2023 and a lower chance of a second hike by end-year. Moreover we consider the suggestion of a faster pace of rate increases – certainly relative to our forecasts for the Federal Reserve first rate hike in June 2023 – as likely to lead to an inflation-dampening rise in sterling.

Financial markets posted a quick and hawkish initial reaction to the Bank of England releases today, with rates and sterling rising swiftly. However, the ensuing press conference, which further explained why the reduction in asset purchases should not be considered a monetary policy shift and a stress of the perceived transitory nature of inflation increases led to a retracing of some gains. After an initial rise of 3bps 2-year and 10-year gilt yields settled back to +1bps (0.046%) and +2bps (0.82%) respectively. Sterling rose by around 0.3% to both the US dollar and the euro, before falling back by around 0.1% against both. Moreover, the short-sterling interest rate strip was around 1bp lower over 2021-2023 inclusive.