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Our views 03 October 2022

UK: Fast changing environment, but end to rate hikes not in sight yet

5 min read

In just over a week a lot has changed for the UK economy. The Bank of England’s (BoE) November policy meeting feels a long time away given how fast the fiscal policy and market environment have been changing. The BoE, however, continue to signal that the next rate move will be in November, rather than intermeeting.

That meeting in November, at the moment at least, looks likely to see a 100bp rate hike in my view. But that view is subject to a lot of uncertainty and markets at least continue to price in something bigger. The 23 September’s fiscal announcements build on top of the energy price freeze and mean the BoE will need to work harder to get inflation sustainably back to target in the medium-term. A higher terminal rate than I’d previously assumed also looks likely (I have now tentatively pencilled in 4.50% by the middle of 2023, again lower than priced in by markets).

However, given this quickly changing market, economic and policy environment, which has already seen the Bank intervening in gilt markets for financial stability reasons this week and a U-turn from the government on abolishing the 45p tax rate, these forecasts may well change again.

Significant policy response: Following the government’s fiscal actions last week and the market’s initial response to the government’s fiscal policy (sharply higher bond yields and a sharply weaker currency), BoE Chief Economist Huw Pill made clear in a speech that the combination of fiscal news/anticipated fiscal loosening, market action (at that point) and the economic implications of those will require a “significant policy response”, making clear that in his view, the combination of fiscal announcements would act as a stimulus to the economy.

(At least) Three complicating factors for the BoE: Working out how much the BoE will need to raise rates and anticipating how the BoE forecasts will change is not straightforward, however.

First, the government’s fiscal plans may change between now and 23 November, with the government already U-turning on one key plank of their 23 September fiscal announcements (getting rid of the 45p tax rate). The government could announce big spending cuts, for example, substantially reducing how stimulative the government’s overall policy measures look likely to be.

Second, by the time of the Bank’s next meeting in early November, the government indicated in their ‘mini-budget’ that we should expect more policy announcements on measures intended to boost the supply-side of the economy (over October and November they intend to make changes to things from the planning system to childcare to immigration). It is questionable how quickly and strongly any of these measures – or those announced on 23 September) will boost supply, especially against an environment where the unemployment rate is low, economic uncertainty is high and the cost of borrowing has risen so much. However, government actions will work on both demand and supply to a degree. The more supply increases, the less inflationary the package of measures (crudely).

Third, financial markets have moved a great deal and partly in response to fiscal policy changes. Since the last set of Bank of England forecasts were produced in August, at the time of writing, the 5 year gilt yield is more than 2pp higher. Mortgage rates have risen in turn and there have been reports of lenders withdrawing products; financial conditions have tightened and credit supply looks to have been hit too. However, sterling has also weakened significantly on a trade-weighted basis since the MPC last updated their forecasts which should work in the opposite direction to boost inflation. Adding to the complications, if the Bank of England disappoint market expectations for rate rises on 3 November, and in the absence of reassuring policy actions from the government, that could lead to further market turbulence.

Hence, in addition to the usual plethora of economic data, there will be a lot for the Monetary Policy Committee to unpick by the time of the 3 November meeting and unhelpfully the government seem determined not to hurry the publication by the Office of Budget Responsibility of a full set of fiscal analysis either (still scheduled for 23 November).

More inflation, still recession: Inflation looks set to be higher over the next 12-18 months than I’d forecasted in the aftermath of the energy bill freeze. That reflects the mini-budget and a weaker sterling. But an assumed stronger response from the BoE alongside already higher bond yields and mortgage rates means that UK recession still looks likely to me too. However, with things moving so fast in the UK, there is a relatively wide range of possibilities ahead for the economy and the monetary policy environment. More forecast changes from UK economists seem likely in coming months.

This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.