Time to “act forcefully” or continue with a “steady hand”?

The tough trade-off the MPC faces between growth and inflation is back in the spotlight when the Bank of England meets to deliver its latest rate decision on Thursday. Recent comments by Governor Bailey have put a 50bp hike on the table but given there’s not been a lot of recent economic data to signal a bigger move, there is a chance we simply get another quarter point rate hike. This means we are likely to see a split vote among policymakers.

The June meeting saw the bank update forward guidance noting that the scale, pace and timing of more rate hikes would depend on “indications of more persistent inflationary pressures”. Any evidence of such second-round effects would see the MPC “act forcefully in response”. Money markets are convinced that the bank will step up and follow other major central banks around the world with a bigger rate hike. Around 45bps of tightening are priced in and the consensus too, expect the MPC to lift rates by 0.5pp taking the Bank Rate to 1.75%. This would mark the largest single Bank Rate increase since 1985.

Inevitably, the bank is under pressure to abandon the current gradual approach to raising rates. The IMF just this week argued that this would simply lead to a more disruptive adjustment later. They pointed to the UK as one of the countries where the inflation outlook had worsened the most and urged policymakers to take “decisive action” even if it hit growth, jobs, and wages in the short term.  The recent depreciation in the pound over the last few months also reflects a perception by markets that the UK is failing to keep pace and falling behind its central bank peers.

But, while inflation is predicted to rise into double digits in the autumn, the MPC will be concerned about the knock-on effects on consumer and business activity going forward. On the flip side, recent data suggests there are continuing labour shortages, though the tightness in the labour market is potentially slowing. These competing forces add up to a tricky decision for the bank who will also release updated growth and inflation forecasts. If these are upgraded, then the emergence of second-round effects should be enough to lift the bank’s CPI projections. That said, we note that the MPC has repeatedly signaled that inflation would fall below its 2% target in the medium term if rates rose in line with market pricing.

Any guidance on the expected pace of future rate increases at upcoming meetings will be seized upon by markets. They have set a high bar for sterling to appreciate with another 50bp rise in September discounted already and rates peaking close to 3% early next year.

Written by Jamie Dutta, Market Analyst for Vantage