The Bank of England this week will consider whether to push through the biggest interest-rate increase in 33 years to respond to surging inflation and weakening confidence in British assets.
With prices rising five times faster than the UK central bank’s 2% target and the pound falling almost daily, policy makers led by Governor Andrew Bailey are under pressure to step up the pace of monetary tightening.
Prime Minister Liz Truss’s move to protect households from rising energy bills will add a jolt of stimulus to the economy, softening the downturn that analysts and the BOE had been expecting. The US Federal Reserve is likely to push its key rate further past lending costs in the UK, potentially further weakening sterling.
“The arguments for a 75 basis-point move are more compelling than those for a 50 basis-point increase,” Paul Hollingsworth, chief European economist at BNP Paribas, wrote in a note to clients.
What Bloomberg Economics Says …
“A 75-bp increase remains possible, but we think the government’s emergency energy support package reduces the need to up the hiking pace by ensuring a lower inflation peak and a faster decline next year.”
–Dan Hanson, Bloomberg Economics. Click for the PREVIEW.
The majority of the 47 economists surveyed by Bloomberg expect the BOE to raise its benchmark lending rate a half-percentage point to 2.25% on Sept. 22. Investors on Friday were pricing in just over a 50% chance of a three-quarter-point increase, reining in those bets from a peak of 80% several times in the past few weeks.
Complicating this month’s decision are the politics of the BOE’s nine-member Monetary Policy Committee and Bailey’s aim to start selling off more of the £895 billion ($1.1 trillion) of assets the bank built up stimulating the economy since the global financial crisis more than a decade ago.
Michael Saunders, one of the most hawkish members of the panel, stepped down last month and was replaced by Swati Dhingra, whose views on rates aren’t well known. The BOE had planned to endorse so-called quantitative tightening, where bonds from the asset portfolio will be sold, but Truss’s decision to borrow huge sums to head off a winter spike in energy costs has introduced an element of doubt.
“Questions have been raised whether this is the opportune moment to sell gilts back into the market,” said Ellie Henderson, an economist at Investec.
The 50 basis-point increase delivered by the BOE in August was the largest since early 1995 — two years before the Treasury handed the BOE authority to set monetary policy.
A 75 basis-point increase next week would be the biggest since 1989, when inflation was climbing rapidly following a consumer boom. Bigger rate rises were announced during a brief and unsuccessful attempt to bolster sterling during the 1992 exchange rate crisis, but they were unwound within a day.
On Friday, sterling marked the 30th anniversary of “Black Wednesday” — Sept. 16, 1992 — by falling below $1.14 for the first time since 1985. UK government bonds have also underperformed peers recently, with 10-year yields climbing as high as 3.22% last week, the highest in more than a decade.
This month’s meeting for the BOE, delayed a week by the death of Queen Elizabeth II, has split the debate among economists and policy makers about how to respond to conflicting forces buffeting the UK economy.
Inflation is forecast to rise further, and companies are struggling to find the staff they need to fill open jobs, pushing up wages and providing a constraint on how quickly they can grow. At the same time, the tightest cost-of-living squeeze in a generation is darkening the outlook.
The hawks, led by BOE policy maker Catherine Mann and economists at BNP, JPMorgan and Credit Suisse, argue that tamping down on inflation is the top priority and that the BOE can’t fall further behind the Fed. They see the Truss energy-cost freeze keeping prices more elevated into next year than the BOE is expecting.
“Opinions are evenly divided, but we see clear reasons for a larger move,” Allan Monks at JPMorgan wrote in a note to clients. “A 50 basis-point hike would amount to a dovish surprise, and this would be hard to justify after a large, unfunded and not-well targeted fiscal easing, which has been accompanied by falling confidence in markets.”
Doves including the BOE’s Silvana Tenreyro are increasingly worried about the economy slipping into a protracted slump that will take the wind out of inflation. Some see the increase in natural gas and electricity prices weighing on activity of all kinds and the BOE moving toward cutting rates sooner than markets anticipate.
“The broadening economic slowdown is a growing challenge to any further tightening,” Fabrice Montagne, an economist at Barclays Plc, wrote in a note. “We expect dissenting dovish voices to become louder.”
Investors are betting rates peak above 4.5% next year, and in recent weeks they’ve almost priced out the prospect of cuts in the benchmark lending rate that they had been anticipating toward the end of 2023.
A day after Thursday’s announcement, Chancellor of the Exchequer Kwasi Kwarteng is due to give a statement to Parliament setting out more detail on Truss’s energy program and confirming plans to reverse a recent rise in payroll taxes.
The cost to the taxpayer in terms of extra government borrowing is expected to top £100 billion, leaving the BOE facing difficult decisions about both rates and asset sales.
“They could choose to delay the commencement of active selling of gilts, recognising the additional gilt supply coming down the tracks, but at the same time raise interest rates by 0.75% on the basis that while the energy price cap will cause headline inflation to be materially lower than under prior forecasts, other expected fiscal measures should be stimulatory,” said Howard Cunningham, fixed income portfolio manager at Newton Investment Management.
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