The Bank of England have effectively signalled that they could raise rates as early as next month in what seems quite a change since the August Monetary Policy Report.
My previous forecast for a first rate rise in 2023 looks untenable in the light of implied Bank of England sensitivity to current levels of inflation expectations and pay growth figures; with the labour market tighter than expected on the eve of the furlough scheme ending; and with the level of output in the economy already closer than expected to pre-pandemic levels after back-revisions to the data. A February 2022 rate rise now looks likely, but a November 2021 rate rise is a risk.
Change in signalling from the Bank: The Bank of England’s August economic forecasts in their Monetary Policy Report were barely even consistent with a small rate rise in even 2022, let alone 2021. Their September meeting minutes, however, signalled that a November 2021 rate hike was a possibility, a message effectively reiterated shortly after in a speech from Bank of England Governor Bailey. There has been no push back from the Monetary Policy Committee (MPC) at the time of writing to markets having priced in a rate rise by year end. MPC member Saunders (admittedly one of the more hawkish Committee members) welcomed the change in market pricing saying that “I think it is appropriate that the markets have moved to pricing a significantly earlier path of tightening than…previously”.
Signalling a ‘live’ decision is not the same as signalling a rate rise: The MPC haven’t really prepared the UK public for a rate hike, though there is still time before the November meeting, and in the Bank of England’s own household inflation attitudes survey some 43% of respondents already expected a rate rise over the coming 12 months. The signal itself was in the somewhat oblique form of saying that the Bank would raise rates, if a rate rise was appropriate, before ending its current asset purchase programme. With asset purchases already due to end in December, that made the November meeting a ‘live’ decision on interest rates having not been considered so before (because the Bank would at that point have only a very partial picture of the state of the labour market post-furlough). Perhaps the Bank is more trying to signal that the risk on monetary policy decisions is now two-way having effectively been one-way for some time.
High inflation is/will be transitory: The best explanation for the apparent sharp shift in Bank of England signalling is that they have become more worried about medium-term inflation risks. However, it is still hard to think of the recent and prospective rise in Consumer Price Index (CPI) inflation as anything but transitory, driven by factors including: higher energy prices (energy prices aren’t expected to rise year after year at their recent pace); global supply chain and labour shortage problems (a good chunk of these can ultimately be traced back to Covid and a struggle to adapt to the massive swings in demand and supply – including labour availability – that resulted); and Eat out to Help Out and VAT base effects (prices cut last year, but unchanged or raised this year).
But there are reasons for heightened worries around the inflation outlook: While high inflation looks transitory, there are two sources of more persistent inflationary pressure that inflation targeting central banks will be particularly sensitive to and where the Bank of England would justly have some cause for concern: 1) Prospects for persistent tightness in the labour market/wage pressure; 2) higher medium-to-longer term inflation expectations which could mean ‘temporary’ inflation shocks having a longer-term impact.
Worry #1: Persistent higher pay growth (without offsetting persistent higher productivity growth): UK wage growth has been affected by base effects and mix effects, but it is pretty robust already underneath all that. The latest estimate of ‘underlying’ average earnings growth from the Office for National Statistics (ONS) is a range of between 4.1% and 5.6%. That looks very high, especially when set against weak rates of productivity growth in recent years. These rates of pay growth may prove more persistent than expected if some of the labour shortages affecting businesses prove sticky. It may turn out that significant inflationary pressure starts to be generated at higher unemployment rates than before. That might reflect a less flexible labour market with EU workers having previously provided something of a ‘pressure valve’ for the UK labour market previously. Problems of skills mismatches for available jobs are also unlikely to have a neat short-term solution.
The Monetary Policy Committee is set to review its understanding of the supply picture for the UK economy in November, including questions of slack in the labour market and in the overall economy. However, with the dust not having settled on the furlough scheme (or Covid) any such judgements are likely to come with a high dose of uncertainty.
Worry #2: Higher inflation expectations: As for inflation expectations, the Bank will be watching business and consumer inflation expectations – as well as market-implied inflation. Market implied inflation has risen and at least one survey measure of 5-10Y ahead household inflation expectations jumped in September to its highest level since a spike in late 2013.
More fundamentally, labour markets and GDP data are signalling less slack in the economy: As the end of the furlough scheme approached, the UK unemployment rate continued to decline, job vacancies remained very high, redundancy rates remained very low and business surveys indicated low levels of job candidate availability. As for the level of economic output, despite disappointing GDP growth over the summer, data revisions have now left the UK closer to closing the gap with at least its pre-pandemic level of output. GDP is now only 0.8% below pre-pandemic levels of output (from ~2% below on the latest available data a month previous).
Not ideal backdrop for a hike though: With supply holding back output in the UK – much of that temporarily – and multiple challenges on the horizon already to demand (not least from the impact of higher energy bills and taxes on consumer incomes) it isn’t the ideal time to be considering a rise in interest rates that will sap demand further and not help raise supply capacity. If the main concern is to address rising inflation expectations, however, then arguably much could be done with a 15bp rate hike relatively early in 2022, taking Bank Rate to 0.25%, sending a signal – alongside waves of central bank communication – that the Bank was willing to see rates lift to curb inflation risks and to follow that by mid-year with another 25bp rate rise if medium-term inflation expectations had not adjusted (more likely at the moment, given building challenges to demand, that second rise would be early 2023).
It makes more sense for the Bank of England to wait until early 2022, bar a further surge in inflation expectations: With the full picture on the labour market post-furlough scheme unavailable, it makes sense for the Bank to wait until February for a rate rise rather than hike next month. The hurdle is probably too high for the majority of MPC members to be comfortable with a rate rise just yet. However, a further jump in inflation expectations measures could well upset that calculus and with cost-of-living issues making daily headlines in the UK a jump in consumer and business inflation expectations in coming weeks is not at all out of the question.
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