BoE preview: are we there yet? Almost

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Significant upside surprises to consumer price inflation virtually guarantee that the Bank of England (BoE) will lift the bank rate by a further 25bp to 4.5% on Thursday. In February the BoE had projected that inflation would average 9.7% yoy in Q1 – the final result of 10.2% remains too high for comfort relative to the BoE’s 2% target. A 25bp rate increase would be in line with ours and the market’s expectation. But while a hike this week looks (almost) like a done deal, the outlook for further hikes thereafter remains uncertain.

In its May Monetary Policy Report, the BoE will likely continue to forecast that inflation will fall not just to the 2%, but sizeably below it, in 2024 as energy base effects wash out and underlying inflation pressures ease. Given the significant tightening which the BoE has already undertaken since December 2021, as well as the uncertain lags associated with monetary policy, economic logic favours a pause soon so that policymakers can take stock and see how price pressures develop. While we put a 30% probability on final 25bp hike at the 22 June meeting, money markets now expect one further full hike 25bp by August. Whether the BoE hikes just once more (our base case) or twice more will not be a decisive factor in shaping the medium-term path of the economy, however.

The one in the middle

In its updated guidance, we expect the BoE to emphasise that it will stick with its data-dependant approach – a de facto repeat of its February guidance. That would keep the door open to further tightening without committing the BoE to it – that would leave the BoE in between a Fed which has signalled that it is now (see Mickey Levy’s note here) on hold and an ECB which has de facto committed to further hikes (see Holger Schmieding’s note here). Future policy decisions will then be taken on the basis of how key inflation fundamentals such as inflation expectations, labour market tightness, wage growth and services prices develop relative to the bank’s expectations.

Economic resilience and inflation surprises outweigh banking sector fears

In the minutes for the March monetary policy meeting the BoE signalled that it would provide an assessment of the economic and financial implications of the US banking sector troubles at the May meeting. So far, the UK banking sector – which is well capitalised and flush with liquid deposits – has not been affected much by the US banking issues. While UK banks will remain somewhat cautious on risk taking, there is little evidence that they are materially curtailing lending as a precaution against potential risk exposures. As a result, the Monetary Policy Committee (MPC) will likely emphasise that it can continue to set monetary policy squarely on the balance of incoming and expected economic data.

This strengthens the case for a further hike this week. In addition to the Q1 inflation surprise, broad measures of economic activity look likely remain more positive than the BoE had anticipated. For instance, in February the BoE projected a 0.1% qoq decline in real GDP in Q1, followed by an even larger 0.4% drop in Q2. However, Q1 was probably flat our even up slightly. With economic data for April – including the PMIs – turning up, the BoE’s February projection for a sharp pullback in Q2 looks far too pessimistic. We expect real GDP to rise by 0.1% in Q2 with risks skewed to the upside.

Whether the BoE is fully prepared to abandon its highly pessimistic view of medium-term prospects on the back of recent upside surprises is an open question. In February the BoE projected that real GDP would decline by 0.5% in 2023 and by 0.3% in 2024 before a small 0.3% gain in 2025. That is well below ours and Bloomberg consensus (in brackets) calls of 0.3% (-0.2%), 1.5% (0.9%) and 1.7% (1.5%) for 2023, 2024 and 2025, respectively. The BoE is also well below the independent Office for Budget’s Responsibility March 2023 highly optimistic projections for -0.2% for 2023, 1.8% for 2024 and 2.5% for 2025.

The BoE takes the overnight index swaps (OIS) curve as its assumption for the path of the bank rate. Since February the OIS curve has moved up 25bp – Chart 2. The small upward shift on the near-term horizon will not impact the updated forecast much, if at all.

Mixed views on the MPC

Now that monetary policy is restrictive, the BoE can afford to move in small incremental steps. The debate on the MPC will thus hinge on two issues. On the one hand, hiking rates until inflation has fallen to close to the 2% target would virtually guarantee that the BoE will have overtightened in the end – which would cause a needlessly large decline in output and employment later on. On the other hand, pausing already while inflation remains so far above the 2% target may be viewed as reckless and could risk harming policymakers’ credibility.

At this week’s meeting, the hawkish narrative will probably provide the basis for seven out of nine MPC members to vote for a further 25bp hike. The two policymakers who voted to hold in March (Swati Dhingra and Silvana Tenreyro) will likely do so again. But as inflation falls quickly in coming months, the case to pause will become more compelling.

Outlook for bank rate

After hiking rates to a peak of 4.5% (or possibly 4.75%), we expect the BoE to remain on hold until Q4 when it will likely begin to cautiously cut the bank rate. While the rapid easing of headline inflation as well as a softening of underlying inflationary pressures will allow the BoE to take policy from tight to close to neutral next year, policymakers will fear restoking inflationary pressures during the 2024 upswing if they ease too much. Following 50bp in cuts during Q4 2023, we expect the BoE to cut the bank rate by just 100bp during 2024 to 3.0% by the end of the year – where the bank rate will remain through 2025.

Quantitative reversal

As long as bond markets remain orderly and the BoE does not run into zero-lower-bound constraints during its next easing cycle, policymakers are likely to keep quantitative tightening (reversal) running in the background for the foreseeable future. The BoE has signalled that it will provide regular guidance and updates on its balance sheet policy as part of its standard policy announcements.

Chart 1: Inflation in Q1 2023 exceeded the BoE’s February projection

Quarterly data. Source: BoE, ONS

Chart 2: Money market expectations for BoE bank rate

Based on overnight index swap curves. Source: BoE

Kallum Pickering
Senior Economist, Head of ESG & Data, Director

Mobile +44 791 710 6575

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