BoE paves the way for steeper rate rises

BoE View: MPC makes hawkish pivot despite weak macro environment

The vote split was the same as in May, with three members voting for a 50bp hike and six for 25bp, though this time there was no dovish dissent against forward guidance for more rate rises to come. Indeed, the policy statement removed reference to ‘risks on both sides’ of the outlook from the May statement, with the emphasis firmly on inflation: the MPC ‘would be particularly alert to indications of more persistent inflationary pressures, and would if necessary act forcefully in response.’ We took this as a strong signal that a 50bp hike is now very much in play for the majority of MPC members at the August meeting. Although the growth picture has if anything darkened since the last meeting, with the economy expected to contract in Q2, the MPC noted that the outlook for underlying growth was broadly unchanged since May. The MPC appeared instead more concerned by signs of increased labour market tightness, with survey evidence pointing to a pickup in wage settlements since May, and a ‘significant minority’ of companies reporting ‘mid-year top-ups to pay’. This ‘reinforced the upside risk to the MPC’s central projections for pay growth and domestic price pressures highlighted in the May Report.’ The MPC appears increasingly concerned about the formation of a wage-price spiral, a risk that looked smaller at the time of the May policy meeting.

We now expect a 50bp hike in August, and Bank Rate to peak at 2.5%

Following the meeting, we have significantly changed our outlook for rate rises in the UK. We now expect a 50bp rate hike in August, up from our previous expectation of a 25bp move. This would bring Bank rate to 1.75%, which is roughly the midpoint of the estimated neutral rate range given by MPC member Michael Saunders in May of 1.25-2.50%. With that said, a 50bp hike in August is a fairly close call given that the BoE started its hiking cycle much sooner than other central banks, and so there is less of an urge to catch up as is apparent elsewhere. In any case, after the August hike, we expect the MPC to downshift back to a 25bp pace, ultimately taking Bank Rate to 2.5% by December – which we expect to be the peak in rates. This is much higher than our previous expectation for rates to peak at 1.5%, and reflects that despite the very weak growth outlook, there is a growing risk that inflation is developing self-sustaining momentum that will be harder to shift if it is not dealt with quickly. We also think the currency is becoming a bigger factor. With central banks across advanced economies now raising rates aggressively, there is a risk of significant sterling weakness if rises in Bank Rate do not keep pace with policy rates elsewhere. This would put further upward pressure on inflation down the line. 

Will the BoE need to cut rates once the inflation hump has passed?

The peak we now have in Bank Rate is still well short of current market pricing, which foresees the BoE raising rates to 3.5% by next May. We think that by later this year, the economy should have sufficiently weakened to drive a rise in unemployment and a cooling in wage growth. Combined with a broader fall in inflation in the first half of next year, this could raise the prospect of the MPC reversing course and cutting rates to support growth, perhaps in H2 2023. Indeed, the MPC’s projections from May – which were predicated on market pricing for Bank Rate to peak at 2.5% – pointed to a significant rise in unemployment and an undershoot of the 2% inflation target in the medium term (see here). Unless the Bank’s internal neutral rate estimate has changed, this suggests rates are unlikely to stay this high for very long.