Investors wait for signs the Bank of England’s heavy lifting is done


The Bank of England is set to keep its options open on whether UK interest rates will peak at 4.25 per cent or 4.5 per cent, after it raises rates for the tenth consecutive time later this week.

The BoE is also expected to signal that once interest rates peak, it will need to keep them high for some time before it can be sure to have defeated high inflation.

The bank’s Monetary Policy Committee is expected to raise rates by 0.5 percentage points to 4 per cent at noon on Thursday, according to a large majority of economists polled by Reuters.

While a rate rise is almost universally expected, there is less consensus on how much more work the BoE will need to do thereafter in order to cool the economy sufficiently to bring inflation under control.

Andrew Bailey, BoE governor, last week said that the path towards lower inflation would be “easier” than previously thought with lower wholesale gas prices limiting the depth of the downturn needed to quell price rises.

But he pointedly refused to say that financial market expectations that UK interest rates will peak at 4.5 per cent were wrong.

He noted that the MPC in December had not suggested markets were “out of line” with the BoE’s thinking as it had in November, when markets expected a considerably higher peak interest rate of 5.25 per cent.

Inflation stood at 10.5 per cent in December after falling back from 41-year peak in October.

Economists are divided on how high UK interest rates ultimately need to go with that division likely to be replicated on the MPC itself.

Karen Ward, chief European market strategist at JPMorgan Asset Management, said she expected interest rates to rise to 4.5 per cent.

“Although activity is clearly slowing in the UK, I’m not yet convinced that it will be sufficient to reduce underlying inflationary pressure,” Ward said. Recent wage and employment intention data “suggest that if anything the momentum in the labour market is improving, not deteriorating”, she added.

In contrast, Jagjit Chadha, director of the National Institute of Economic and Social Research, said that neither the MPC nor the economics profession properly understood the effect of raising interest rates from almost zero to the current rate of 3.5 per cent so quickly.

“The danger is that we go too far too quickly,” he said, adding that, “with inflation set to fall mechanically this year, rates ought to climb only a little in small steps and rest at around 4 per cent”.

The BoE started raising interest rates in December 2021, followed by subsequent increases of at least 0.5 percentage points in every meeting since August last year.

Financial markets and most economists think a majority on the MPC will opt for another “forceful” 0.5 percentage point increase, which would match the rate rise in December and bring rates to 4 per cent.

The vote is likely to be split because two members of the MPC, Swati Dhingra and Silvana Tenreyro, voted not to increase rates from 3.5 per cent at the December meeting.

Philip Rush, founder of the consultancy Heteronomics, said that private sector regular wage inflation of 7.2 per cent in the three months to November would worry the BoE and was not compatible with bringing inflation down to its target of 2 per cent in the medium term.

To address these worries, he said he expected the MPC “to reinforce its credibility with another 0.5 percentage point hike in February ahead of April’s critical wage round”.

Line chart of Change in private sector regular wages (YoY, %) showing Private sector wages are growing at their fastest rate since 2000 outside the pandemic period

Pay is one leg of a feared wage-price spiral that could keep inflation too high for too long. The other is the ability and willingness of companies to raise prices and these also look concerning for the BoE.

Core inflation — excluding food and energy — has been stuck around 6 per cent for the past nine months even as headline inflation peaked in October and has since been falling.

The committee is unlikely to feel reassured that lower energy prices later this year will bring underlying inflation down sufficiently rapidly.

The BoE’s own survey of companies in its Decision Maker Panel, for example, showed companies are still expecting to raise their prices by 5.7 per cent in the year ahead.

Alongside the decision on interest rates, BoE watchers will also be interested in the economic projections produced by the central bank and commentary by officials [as guidance] on how much more action the bank will take.

Line chart of CPI inflation (%, year on year) showing Headline inflation has peaked, but core inflation has stuck around 6 per cent for nine months

The bank’s forecasts are likely to show headline inflation falling fast later this year, and in 2024, reaching the 2 per cent target in roughly two years before dropping below the target for a period.

James Smith, research director at the Resolution Foundation think-tank, said the key signal was the inflation forecast at the “policy-relevant horizon” of around two years, and whether the BoE believes “underlying inflation might prove more persistent” than previously thought.

He also noted that the February meeting allows the BoE to rip up its previous forecasts and come to a fresh view, as it coincides with the MPC’s annual stock take of the economy’s ability to grow without inflation.

The BoE could modify its view on how many people it thinks are looking for work and the productivity performance of the economy, both of which would influence its view of inflationary pressure.

“The MPC became much more pessimistic about supply potential last year without saying a lot about what was driving that view,” Smith said.

Focus on the BoE’s signals after its decision will be intense. Bailey’s recent suggestion of an “easier path” ahead suggest it now sees a way to return to price stability with less pain from higher unemployment and the longest recession since the second world war.

The governor is expected to reiterate a tough message on prices, however, because any failure to bring inflation down would destroy his reputation and that of the bank’s independence to set monetary policy.

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