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UK Reaction: BoE adopts neutral outlook, we consider it a peak

  • 11 May 2023 (3 min read)

• The Monetary Policy Committee (MPC) hiked Bank Rate by 25 basis points (bps) to 4.50%, by 7 votes to 2, in line with ours and market expectations.

• The Bank of England (BoE) raised its GDP outlook, no longer seeing recession reflecting global growth, energy prices and a fiscal boost.

• The BoE forecasts GDP growth at 0.25% for 2023 and 0.75% for 2024 and 2025.

• It also raised its inflation profile, in the short term with stickier food prices and in the medium-term due to firmer growth.

• The BoE sees inflation at target by around end-2024, settling around 1%, averaging 7.6%, 3.3% and 1.2% over 2023, 2024 and 2025.

• Governor Bailey stated that the MPC has no bias, with any further hikes depending on more inflation persistence.

• We believe the BoE has reached a peak of 4.50%, below market expectations for 4.75%, but with upside risks if labour markets continue to be resilient.

• We change our outlook for a rate cut by year-end, now seeing the first cut in Feb 2024 and rates closing 2024 at 3.5%.

The Bank of England’s (BoE) Monetary Policy Committee (MPC) raised Bank Rate by 0.25% to 4.50% in line with our own and market expectations. The vote was 7-2 with two members Dhingra and Tenreyro voting to leave rates unchanged. The MPC struck a more balanced tone in today’s meeting with Governor Bailey stating that the Committee had “no bias” and that a further tightening in policy would only be necessary if further signs of inflation persistence emerged. The BoE materially upgraded its GDP outlook and continued to emphasise the upside risks to its “modal” inflation forecasts, but also devoted more time to discussing the full impact of rate hikes which it explained were likely to pass through into the economy more slowly than in previous cycles.

The MPC’s decision to raise Bank Rate came alongside the publication of its Monetary Policy Report (MPR) and updated economic projections. The BoE's view of growth has shifted up materially – a total increase of over 2ppt over the forecast horizon with the BoE now expecting GDP growth to average 0.25% this year and 0.75% in 2024 and 2025 (up from -0.5%, -0.25% and 0.25% respectively in February). This was the biggest 3-monthly adjustment in the MPC’s history and reflected changes in the Bank’s background assumptions: stronger global growth, lower energy prices, a fiscal boost and stronger domestic demand underpinned by a more resilient labour market.

The Bank also raised its forecast path for inflation, now seeing inflation falling towards target by end-2024 and settling around 1% thereafter. This upgrade was driven by increases to goods prices, food in particular, in the short-term, while the longer-term reflected the firmer growth outlook and an expectation of less economic slack. Overall, the BoE forecast inflation to average 7.6% this year, 3.3% in 2024 and 1.2% in 2025 (from 7.0%, 1.8% and 0.7% respectively). But the BoE considers risks around the forecast remain skewed to the upside, and it continues to question the fading of second round effects in standard models, which point to inflation falling below target beyond 2024. The risks to the upside are formalised in the historic skew between the bank's central (modal) forecasts and the risk-weighted (mean) forecasts, with the latter pointing to inflation stabilising around 2% by early 2025.

With Bank Rate now standing at its highest level since 2008 and inflation still in double-digits the question remains - have we reached a peak? We think so, but as the Governor stressed this is fully data dependent. Bailey explained that the MPC no longer had a hiking bias, which although did not change the precise language from March’s meeting, did come with a broader change in tone. The Bank continues to focus on inflation persistence, an assessment that revolves around three factors: labour market tightness, wage growth and services inflation. A further hike from here would likely depend on a surprise relative to these factors. Between now and the next meeting on 22 June, we will receive two additional months' worth of labour market and inflation data which will be instructive. However, the BoE explained that wages and services inflation, while elevated, had been in line with expectations. It has been the resilience of the labour market that has caused most surprise, although the Bank echoed our own assessment that forward-looking indicators suggest some softening here.

The BoE is also considering the lags to the 4.40% increase in Bank Rate it has implemented since December 2021. The Governor today argued that changes to the structure of the UK mortgage market meant that the pass through of tightening to the household sector was likely slower than in previous cycles. Illustratively, the Governor showed that the effective mortgage rate of the whole mortgage stock had broadly risen by around 70bps, while new mortgage rates were some 300bps higher. This suggested the scale of additional tightening still to impact the economy. This alone suggests that absent any large surprises in inflation persistence over the coming months, the Bank is likely to be content to review this assessment not necessarily at its next meeting in June, but at the following Monetary Policy Report meeting in August. Coupled with our expectations for a more obvious easing in the labour market by then and global uncertainty surrounding the passage of the US debt ceiling, we think that, on balance, Bank Rate at 4.50% will prove to be a peak.

However, in light of the BoE’s growth upgrades and its ongoing doubts about second-round inflation effects, we change our outlook for rates thereafter. We had forecast a rate cut from the BoE before year-end. However, we see the divergence between the Bank’s mean and modal forecasts as being decisive. If the MPC considers the mostly likely (mean) outlook to converge on current modal forecasts, that is if its upside skew to risks fades, we think that it will begin to ease policy. However, we are no longer confident that this will occur by year-end. We shift our forecast for the first cut back to February 2024, recognising that at that meeting the Bank will have agents’ updates on 2024 wage negotiations. This should give the Committee more confidence in the loosening of the labour market. We then forecast rates easing from 4.50% to 3.50% by end-2024.

Markets at first interpreted the BoE’s announcement hawkishly with market pricing for Bank Rate at end-year, 2-year and 10-year rates rising. However, everyone retraced these increases as Governor Bailey delivered his press conference. For August, markets continued to see the BoE at 4.75% (-1bps after today’s announcement) and this persisted for December (-4bps). 2-year gilt yields reversed an initial 6bps gain to fall 6bps from the announcement to currently trade at 3.74%, while 10-year gilt yields are currently 4bps lower at 3.71% than before the announcement. Sterling echoed these moves, first rising to both the US dollar and euro, then falling, currently down 0.4% to the dollar at $1.252 and -0.3% to the euro at €0.872.

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