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We have previously highlighted the rising probability of the
Bank of England delivering an initial hike in policy rates as soon
as its next meeting on 4 November.
This followed the publication of the minutes of the previous
meeting of the Monetary Policy Committee (MPC) on 23 September. At
the time, financial markets were pricing in a first rate hike only
in March 2022, with most forecasters (though not IHS Markit)
predicting it much later in the year.
The recent sharp rise in 2-year yields, and the consequent
curve flattening, suggest a rising risk of over-tightening and a
hard landing for the UK economy.
MPC signals tightening is on the way
There were various signals pointing in the direction of an early
rate hike in September's MPC minutes, including:
Recent developments had "strengthened" the case for some policy
tightening. "Inflationary pressures remained strong" and there were
signs that cost pressures "may prove more persistent".
While the MPC's central expectation continued to be one of the
transitory global cost pressures, its forecast for UK CPI inflation
was markedly revised up again. The inflation rate was expected to
rise above 4% in Q4 2021.
Two MPC members voted for a tightening via an immediate end to
the asset purchase program (which is scheduled to run until the end
of the year).
All nine members of the MPC agreed that any future initial
tightening of monetary policy should be implemented by an increase
in the key policy rate, even if this were to occur before the end
of the asset purchase program.
A stitch in time?
The arguments favoring a rate hike as soon as November
include:
Since September's upward revision to the MPC's near-term CPI
projections, energy prices have risen markedly, necessitating a
further upward adjustment.
Market-derived measures of inflation expectations have
continued to rise from already uncomfortably high levels. The
5-year, 5-year forward inflation swap rate is now close to 4%,
double the Bank of England's 2% medium-term target.
Job vacancies have continued to increase, hitting a new
all-time high, indicative of heightened labor shortages and an
increasing risk of "second round" effects on inflation via higher
future wage growth.
The two MPC members voting for an end to asset purchases in
September judged that, under the existing policy stance, inflation
was likely to remain above the 2% target in the medium term. More
MPC members are likely to have come around to that view given the
news in the period since.
Some MPC members will have merely been waiting for confirmatory
evidence that policy tightening is required. November's updated
forecast assessment in the quarterly monetary policy report (MPR)
could provide that evidence.
The two MPC members voting for an early end to asset purchases
in September also cited the strategic benefit of a moderate, early
policy tightening. This would mitigate the risk that a more abrupt
and destabilizing tightening in policy might be needed further down
the line. It would also demonstrate the MPC's commitment to
returning inflation to target and would ensure that medium-term
inflation expectations remained well anchored. More MPC members may
also have come round to this view by the time of early November's
meeting.
Comments from Bank of Governor Andrew Bailey and other MPC
members have hinted at a shift in position, expectations with his
recent comments, including a confirmation that the MPC will "have
to act" in response to inflation developments.
Or play for time?
A November hike is not quite a done deal. Counter arguments
against it include:
MPC members have cited considerable uncertainty over the
outlook and underlying inflationary pressures. There has been a
general preference therefore to wait for additional information
which could help to clarify the outlook.
In particular, there is high uncertainty about labor market
trends and potential labor shortages, which are pivotal to
medium-term inflation prospects. Once the impact of the end of the
UK's furlough scheme is more apparent, the uncertainty should
recede. While the MPC will review labor market developments as part
of its forthcoming forecast round, it may be too soon to make a
judgment.
Survey of households' inflation expectations have risen but by
much less than market-derived measures. The survey of expected
inflation over five years rose to 3.0% in August but this was still
below its historical average of 3.2%. Still, with CPI inflation to
rise markedly further, a pick-up in survey expectations is very
likely.
A rate hike in November could "scare the horses", fueling
expectations of multiple additional hikes in 2022 and beyond. The
Bank of England might struggle to rein in expectations and an
abrupt tightening of financial conditions could exacerbate the
slowdown in UK growth momentum already evident in various
indicators.
A close call
IHS Markit's October baseline forecast was for an initial hike
in Bank rate in February 2022 (of 15 basis points to 0.25%), in
tandem with the subsequent MPR, due to a perceived preference among
a majority of MPC members to wait for more information. Still, it
would not come as a major surprise if the move occurred in
November, for the reasons highlighted above.
At the time of writing, the implied probability from OIS markets
of a 15 basis point rise in November is greater than 50%. This
removes one potential impediment to immediate action from the Bank
of England: that it would come as a shock.
As we see it, it is merely a question of when not if the Bank of
England starts raising policy rates. The discussion surrounding
November's meeting is predominantly a strategic one. The potential
benefits of acting sooner to prevent even more tightening later,
set against a possible preference to wait and see given the various
uncertainties surrounding the outlook at present.
How would markets react?
With a 15 basis point hike not fully discounted for November at
the time of writing, it would push up the pound and short-term bond
yields, though both have already risen recently as rate hike
speculation has mounted, particularly the latter.
The voting from MPC members will be important. A unanimous 9-0
vote in favor of a hike in November would send a strong signal. But
only a narrow majority in favor of a hike, with some members
favoring a more cautious approach, could temper future rate hike
expectations.
The accompanying communication from the MPC will also be
pivotal. In the event of a hike, rate expectations for next year
will likely shift higher in the absence of a clear signal that the
MPC will be cautious in its withdrawal of policy accommodation and
that by moving early, it is likely to deliver less tightening
overall. In the event of no rate hike in November, any relief rally
would likely be limited given the high likelihood that the MPC
would signal that a rate hike would likely follow soon after.
Further out, the key longer-term issue is whether there is a
risk of over-tightening and a possible hard landing for the UK
economy as a result. Given various existing headwinds to UK growth,
including soaring energy prices and future increases in household
and corporate taxes in 2022-23, this to us increasingly looks like
a genuine risk.
Markets appear to see it the same way, with the rise in 2-year
rates leading to a marked flattening of the yield curve. This could
change once the MPC's intentions regarding the unwind of QE have
been made clear. But for now, the signals suggest that while the
market expects a more aggressive Bank of England due to rising
inflation, the UK economy is not resilient enough to take it.
Posted 28 October 2021 by Ken Wattret, Vice President, Economics, IHS Markit