Bank of England: On hold and keeping its options open

The economist view

The Bank of England’s monetary policy committee (MPC) voted to hold Bank Rate at 3.75%. The vote, in line with consensus, was 7-2 with Huw Pill and Megan Greene voting for a rate rise.  

Still taking a scenario-based approach, where market does most of the work

The Bank agreed that the “appropriate policy response should be robust across a range of scenarios”, given uncertainty. “Most members” however, judge that the tightening in financial conditions “provided insurance against inflation risks”. “Some” members noted that a rate rise would help insure that remained the case. But not enough to see them actually hike rates this week.  

As one might expect, lower oil prices were discussed by the committee, but the outlook is still seen as highly uncertain.

Lower oil prices featured

As one might expect, lower oil prices were discussed by the committee, but the outlook is still seen as highly uncertain. It regarded risks to energy prices as still skewed to the upside: “members judged that even in the event of prompt conflict resolution there could be a logistical delay in restoring energy production and transportation...”  

Oil important, but watching for second-round effects

The MPC judged that the direct effects of higher oil prices on inflation, and some indirect effects, have, so far, evolved broadly as it expected. However, it has lowered the short-term inflation forecast “reflecting recent news in energy prices as well as downside news in the May CPI outturn”.  It judged though that it was too early to come to a conclusion on the second-round effects of higher energy prices.  

“All members...agreed that the appropriate policy response would depend primarily on the outlook for second-round effects.” However, views on the risks of second-round effects continued to differ in the MPC. Were second round effects to be contained, there was a “stronger case for tolerating a slower return of inflation to target, in the context of weak activity” (i.e. not hiking rates).

The individual comments indicate a rate hike is much more likely if clearer evidence of second-round effects emerges

Governor Andrew Bailey, recently seen as a swing voter, said “I am content…with holding, while accepting that risks to inflation and interest rates are on the upside”, indicating an openness to hiking rates in the coming meetings. Catherine Mann, while voting for a hold today, emphasised upside risks to inflation, but argued that a “forceful” Bank Rate decision would act quickly on inflation and inflation expectations. Sarah Breeden and Clare Lombardelli both indicated an openness to hike rates should there be evidence of second-round effects, while Swati Dhingra, Dave Ramsden and Alan Taylor seem more firmly on hold for now. In contrast, Greene and Pill both voted for a 25bps hike. Greene argued that “significant uncertainty about the extent of second-round effects” warranted a “risk management strategy”, while Pill continued to place weight on the risk that second-round effects could prove more persistent.

We still think that the risk of second round effects is sufficient to see the Bank ultimately needs to raise rates (once), but the probability has reduced and much will depend how things pan out in the Middle East.

Implications for the monetary policy outlook

Progress in the Middle East and current lower oil prices, should they persist, lower the probability of a rate hike; the Bank sees the second-round effects as likely to be stronger the more persistent the rise in global energy prices. We still think that the risk of second round effects is sufficient to see the Bank ultimately needs to raise rates (once), but the probability has reduced and much will depend how things pan out in the Middle East.  

The fund manager view

At the Bank of England (BoE) meeting on Thursday 18th June, the monetary policy committee (MPC) voted 7–2 to maintain Bank Rate at 3.75%, a decision that was widely expected by economists and financial market participants. Although the presence of two dissenters in favour of an immediate 25bps hike might attract some attention, the majority of the committee continues to emphasise optionality.

The MPC judged that the direct, and some indirect effects of higher oil prices on inflation, have evolved broadly as it expected. However, it is the impact on second-round effects where differences emerge, and in this regard, the collective judgement of the MPC is one of a wait-and-see approach. The committee also noted that financial conditions have already tightened materially since the spring, largely via higher market rates and borrowing costs; this tightening is judged by some to be providing additional restraint without the need for immediate policy action.

The committee also noted that financial conditions have already tightened materially since the spring, largely via higher market rates and borrowing costs

Since the last meeting on 30th April, UK economic data releases have broadly supported the committee’s assessment. May consumer price inflation (CPI) has eased to 2.8%, with downside surprises relative to earlier projections reflecting falls across food, core goods and services. At the same time, labour market indicators continue to point to gradual loosening: vacancies have declined further, underlying employment growth remains subdued, and private sector wage growth has moderated to around 2.9%, close to target-consistent levels. Inflation is expected to rise from here, but a resolution to the conflict, albeit only temporary at this stage, has seen oil prices fall from $105 per barrel to $74 per barrel. This has calmed market fears that an ongoing conflict would see an inflation spike forcing central banks to tighten monetary policy imminently.

In our last BoE blog on 1st May, we noted how the markets’ pricing of the UK’s neutral bank rate had increased from 3.5% to around 4.5%, a rise of 100bps, and how we felt that shorter maturity gilts – five to seven-year maturities – were particularly attractive. Since then, yields on five-year maturity gilts have fallen from around 4.5% to 4.3%, and we have reduced the magnitude of the relative duration positioning across our UK gilt fund range, albeit with a bias to lower yields, led by shorter maturity gilts.

it is the longer-term neutral rate that is central to the valuation of UK gilts

Our house view is that the BoE will hike rates once, from 3.75% to 4% later this year, before cutting rates during 2027 to a terminal rate of 3.25%. Whether the Bank does hike or not – and the probability of that former outcome has surely fallen in recent weeks – it is the longer-term neutral rate that is central to the valuation of UK gilts. There will be plenty of volatility during the summer months, driven by both global forces as well as domestic economics and politics, but for longer term investors, we believe that shorter maturity gilts still remain attractive.

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