Too fast, too furious: how far can the Bank of England afford to hike?
Global Bonds Portfolio Manager Bethany Payne challenges whether the Bank of England can really deliver the interest rate hikes currently priced in by the market.
- The markets’ pricing of rate hikes for the bank rate to reach 1% by the summer of 2022 is, in our opinion, too premature.
- The latest CPI inflation data may not be an alarm bell to the Bank of England to hike as soon as the November meeting, but it is inflation on the horizon that will be concerning. The central bank will need to assess the durability of the UK consumer and whether higher prices will spiral into broad wage growth.
Having laid the groundwork for a rise in interest rates over the last few months, the challenge the Bank of England (BoE) faces is whether it can afford to hike, and also, whether it can afford not to hike.
On one hand, the central bank does not want to choke off the recovery, with UK growth slowing and the full impact of unwinding the furlough scheme as yet unknown. On the other, with the persistence of higher inflation, the BoE faces a credibility challenge with various members of the Monetary Policy Committee (MPC) having taken a more hawkish stance. Ultimately, they will want to avoid a UK version of a 'Trichet moment' or being labelled another 'unreliable boyfriend'. While we will only know in hindsight, the market has already made its judgement.
A 15 basis point (bp) hike at the next meeting, swiftly followed by further hikes to the bank rate to one per cent by Summer 2022*, is too premature a tightening for the UK's fragile economic recovery and will, in our view, ultimately be recorded as a policy error.
*Implied by market pricing
Taking away the wrong message from recent remarks?
Governor Bailey has previously come under criticism for his shifting messages over negative interest rates, but we don't think his remarks are as clumsy this time. Instead, we believe that the market has taken them out of context, disregarding Bailey's comments about the limitations and lack of desire for policy to fix supply-side shocks and ‘the hard yards’ ahead.
Whether his recent hawkish comments were purposefully so, or if he over-egged the pudding, the Bank of England has been clear that it plans to exit extraordinary monetary policy by raising rates first, and when rates reach 0.5%, switch to focus towards reducing its balance sheet.
Taking a cue from Ben Broadbent's speech about US quantitative tightening in 2018, “rate rises and any tightening effect of shrinking the balance sheet should be seen as substitutes. More of the latter would mean less of the former”. In other words, a decisive initial rate hike doesn't necessarily warrant the succession of hikes priced swiftly afterwards. Figure 1 shows the degree to which market pricing has moved over the last month:
Figure 1: market expectations for the bank rate have risen sharply
Source: Bloomberg, Janus Henderson Investors, as at 20 October 2021.
Note: implied bank rate from Overnight Index Swaps.
September CPI data concerning but not an alarm bell yet
We expect more clarity from the Bank of England about how it assesses the impact of a reduction in the stock of asset purchases before rates reach this 0.5% level, but we understand that the requirement is for the economy to be in recovery so that quantitative tightening proceeds smoothly. Only then will the BoE continue to raise rates above 0.5% and, only at 1% bank rate, will it consider actively selling bonds.
CPI inflation for September came at 3.1% year-over-year to September 2021, 0.1% below consensus and August's figure. Transport cost contribution to the annual CPIH (Consumer Prices Index including owner occupiers’ housing costs) inflation rate was at the highest level for almost ten years, adding 0.9% to the CPIH. The price of fuel and semiconductor shortages drove up both transport-related costs and the price of used cars, a phenomenon seen in the euro area and the US. A large negative contribution came from restaurant and hotel inflation as the “Eat Out to Help Out” scheme** base effects led to relatively higher prices in the previous month's report.
While the latest CPI data may not be an alarm bell to the Bank of England to hike as soon as the November meeting, it is inflation on the horizon that will be concerning. From several market surveys, we see businesses no longer absorbing higher factory gate prices through compression of their profit margins. These cost-push pressures will likely be eventually passed on to the consumer, feeding into higher inflation expectations and the spiral of second round impacts. Figure 2 shows where markets see inflation heading in the near future versus the bank’s inflation forecasts.
Figure 2: inflation market's pricing of inflation versus Bank of England forecasts
Source: Bank of England August Monetary Policy Report, Bloomberg, Janus Henderson Investors, as at 20 October 2021.
Note: RPI swap market fixings: retail price index (RPI) swap breakeven rates as an indication of the market’s expectations for future RPI inflation rates.
Three more challenges to consider
The Monetary Policy Committee (MPC) faces three other challenges before the 4 November meeting:
- First, the Bank of England will still be buying bonds in November and December in the preordained asset purchases programme. The incoherency of increasing interest rates when simultaneously buying bonds in the quantitative easing programme will be tricky to navigate.
- Second, Chancellor Rishi Sunak will deliver the Autumn Budget on 27 October, only eight days before the MPC meeting. Further fiscal prudence via tax increases or benefit cuts may reduce the MPC’s expectations around the economic recovery.
- Third, the November meeting will include the MPC's updated forecast for growth and inflation and the supply side of the economy. Updating these forecasts at a time of market uncertainty and higher rates may present a dilemma for the Bank of England. Higher market interest rates would necessitate lower medium-term inflation forecasts (inflation had already been forecast to fall below 2% in two years’ time), but weaker supply-side growth would do the opposite. Updating these forecasts at a time of acute uncertainty will make the outcome particularly uncertain.
The Bank of England will need to assess the durability of the UK consumer and whether higher prices will spiral into broad wage growth. One thing is clear to us — that the bar for the Bank of England to underwhelm current market expectations with later, or fewer rate hikes, is low.
**Scheme ran in August 2020