With the trade-off between rate hikes and inflation reduction proving destructive to growth, inflation expected to cool and the Bank of England needing time to take stock of its previous tightening actions, the Monetary Policy Committee is getting close to the limit on how far rates can go. Some further hikes, though, do look likely.
The 50 basis points rise on 2 February, to 4.0%, is the MPC’s 10th hike since December 2021, giving a cumulative 390bp of rate tightening. But it still leaves real rates in negative territory. When Bank Rate was last as high, in October 2008, it was at 4.5%, in line with consumer price index inflation (Figure 1).
Figure 1. UK policy rate remains significantly under inflation
Bank Rate (%) and its differential with CPI inflation (% point, right-hand axis)
Source: Refinitiv Datastream
A major motivation for this tightening path has been the MPC wanting to reclaim its cherished policy tool, with the additional incentive of reputational repair after the market disturbances last autumn on the UK Treasury’s unfunded tax plans.
These have since been rescinded, contributing to – while not the sole cause of – a less severe expectation in money markets of future rate increases. Markets may be right to expect no more than a 4.5% peak rate being struck around the MPC’s August quarterly economic forecast, rather than the 5% anticipated at the end of 2022.
The biggest surprise to the MPC in running its November 2022 forecast was the steepest inter-forecast lurch in rate expectations the MPC had seen, from a 3% to 5.25% anticipated peak. This was driven by persistent inflation, the 125bp on Bank Rate between August and November and the extra UK risk premium during October.
But, by not going as hard in December and February as the 75bp increase in November (the biggest jump yet), the MPC is closer to taking its foot off the brake. This is to assess both its previous moves – Bank simulations suggest 18-24 months before the full impact of a rate change takes hold in aggregate – and the after-effects of the northern hemisphere winter.
A quid pro quo for fighting inflation is the Bank still expects gross domestic product recession. Yet, with lower-than-expected inflation, the impact of intervening rate rises and lower market rate expectations, it should now be much shallower and shorter than anticipated in November. Based on market rate expectations, GDP is expected to fall by 1% from its peak to trough over five quarters (ending by 2024), versus the 3% fall over eight quarters expected in November. This still makes it about equal in duration to the 2008 financial crisis, albeit ‘gentler’.
Lower energy prices drive the Bank’s lower inflation projections (on which the MPC’s central fan charts are based). Based on market rate expectations, CPI inflation is expected to be 3.9% at the end of 2023, falling back below its 2% target by mid-2024. The relief from lower energy costs is put in perspective by the November forecast requiring a far more restrictive 5.25% Bank Rate to be reached and held for CPI inflation to fall sharply to ‘some way below’ target by 2024.
The Bank’s active quantitative tightening (selling assets) should help, but it needs to stay light to avoid further disruption. This restarted on 1 November after a pause to provide emergency liquidity to pension funds struggling with the unexpected leap in bond yields. And, with Chancellor of the Exchequer Jeremy Hunt’s 2022 autumn statement pushing the hard decisions on UK debt reduction down the line, hopes that QT can fully compensate for rate hikes look unrealistic.
Monetary and fiscal considerations will thus stay entwined. And for as long as Bank Rate remains above the indicative 10-year gilt yield (currently centred on 3.3%), attention will ebb and flow on the UK Treasury’s interim compensation to the Bank for managing its bloated balance sheet. With the Bank’s 2009 indemnity in place, its short-term losses from QE (under the Bank of England Asset Purchase Fund Facility) should continue to be offset by Treasury reimbursement.
Economically, this should be relatively innocuous as balance-sheet risk is minimised by, for example, holding the debt closer to maturity, and short-term income mismatches iron out over time as the traditional relationship between Bank Rate and yields reappears. It should also be viewed with the perspective of significant revenue gains to the Treasury in the first decade of QE, not least (and there are no counterfactuals) as borrowing costs were held down and deflation avoided.
Extending the compensation indefinitely, though, would appear to put extra strain on the public purse. Hunt has limited room for fiscal giveaways in his 15 March budget, and the prospect of further monetary tightening – however slight – on top of recession precludes further fiscal tightening. This is just as well if Prime Minster Rishi Sunak expects a full-blown economic recovery before the next general election.
Neil Williams is Chief Economist at OMFIF.