9 May 2022
The Bank of England’s Monetary Policy Committee (MPC) has voted to increase its Official Bank Rate to 1.00% - their highest rate since 2009. The Bank’s move represented its fourth consecutive rate hike since December – the fastest increase in borrowing costs in 25 years.
The decision means the Bank joins other central banks including the US (+0.50%), Australia (+0.25%), Brazil (+1.00%), Chile (+1.25%) Czechia (+0.25%), Iceland (+1.00%), India (+0.40%) and Poland (+0.75%) in a global push to tackle rising prices.
There had been speculation before the meeting that one or two MPC members might opt for a 0.50% increase, the vote was in fact split 6:3 to raise the Bank Rate by 0.25% with three dissenters, Catherine Mann, Michael Saunders and Jonathan Haskell preferring a larger rise. This represented a change in the dynamic from the previous meeting, when eight members voted for a 0.25% increase, and one opted for no change.
The MPC doubled down on its March narrative, setting out the potential for a marked slowdown in activity over the coming months and sharply cutting its growth forecasts, as the negative impacts from the higher cost of living weighs on household real incomes.
A 0.25% increase was widely expected, with markets implying approximately a 15% chance of a 0.50% increase. Following the announcement, and the more pessimistic comments from the MPC, market expectations for the path of Bank Rate shifted lower. Investors now see rates peaking at around 2.50% in the middle of next year, down from 2.60% before the announcement.
Source: CCLA/Bloomberg.
Despite the rate increase, the Pound fell to its lowest level since June 2020 following the decision and statement, as concerns grew surrounding the growth forecasts and perceived indecision risk within the MPC. Sterling fell just under 1.5% against the dollar to below $1.24.
Rationale behind the increase
The MPC is clearly struggling to navigate a balancing act between runaway inflation and tipping the economy into recession, as a result we have a divided committee and confused messaging. The MPC repeated a form of the guidance it issued in March, when it said ‘some further modest tightening in monetary policy may be appropriate in the coming months.’ However, at this meeting, the minutes highlight a split amongst policymakers with ‘most’ members agreeing to the guidance. The word ‘modest’ was also switched to ‘some degree’, which may indicate that at least one member now thinks interest rates need to rise substantially further.
Confusingly, two members of the Committee judged that the risks around activity and inflation over the policy horizon were ‘more evenly balanced.’ As a result, it seems likely that these two members could vote to keep Bank Rate at 1.00% at the next meeting on 16th June.
The Bank yet again revised up its inflation forecasts and now expects CPI inflation to rise further over the remainder of the year, to just over 9% in Q2 2022 and averaging slightly over 10% at its peak in Q4 2022. The majority of the further increase reflects higher household energy prices following the large rise in the Ofgem price cap in April and a projected additional large increase in October. The expected rise also reflects higher food, core goods and services prices.
Again, the Bank has tried to highlight that it is unable to contain many of the causes of this high level of input inflation:
‘The economy has recently been subject to a succession of very large shocks. Russia’s invasion of Ukraine is another such shock. In particular, should recent movements prove persistent as the central projections assume, the very elevated levels of global energy and tradable goods prices, of which the United Kingdom is a net importer, will necessarily weigh further on most UK households’ real incomes and many UK companies’ profit margins. This is something monetary policy is unable to prevent.’
At the press conference following the decision, Bank Governor, Andrew Bailey kept a similar narrative to that expressed in his recent speeches. Explaining the rate announcement, he said the Bank is walking a very narrow path, citing the spending of savings built up during the pandemic and the tightness of the labour market as potential contributors which could allow for some second-round inflation:
‘The Underlying nominal earnings growth has risen by more than projected in the February Report and is expected to strengthen in coming months, given the further tightening of the labour market and some upward pressure from higher price inflation.’
Given that the Bank is clear that rate rises will have limited effects on input inflation, we continue to view the strength of the labour market as the main justification for the recent rate hikes, as the Bank looks to head off second round inflation effects such as rapid pay growth. However, even this shining light of the post Covid recovery appears under threat with the Bank projecting (albeit after a further near-term reduction) a c.1.5% rise in unemployment in three years’ time, which may ease some of the wage pressures that have built here.
The risk of stagflation
The Bank stressed that the surge in energy and goods prices will have a material impact on the UK economy:
‘UK GDP growth was expected to slow sharply over the first half of the forecast period. That predominantly reflected the significant adverse impact of the sharp rises in global energy and tradable goods prices on most UK households’ real incomes and many UK companies’ profit margins.
Total real household disposable income was projected to fall by 1¾% in 2022, which was a greater fall than in the February projection. Four-quarter consumption growth was expected to slow materially over the first half of the forecast period.’
The Bank kept its forecast for economic growth this year at 3.75%; but cut its forecast for 2023 to show a contraction of 0.25% from a previous estimate of 1.25% growth. It cut its projection for 2024 to 0.25% growth from a previous 1.0%.
It therefore appears that, with inflation projected to be in double digits as we move towards the end of the year and with growth flatlining, we do appear to be approaching a period of stagflation and the future performance of the economy is increasingly looking linked to how much support for households the Chancellor may inject into the economy.
Quantitative tightening
With Bank Rate now at 1%, the MPC has triggered its self-imposed threshold at which it would ‘consider’ the active sales of gilts held in its Asset Purchase Facility. Unlike the US Federal Reserve decision to commence selling its stock-pile last week, the MPC has only asked the Bank of England staff to work on a strategy for sales. Their work will be presented to the MPC at the August meeting, for discussion.
Future path for Bank Rate
We maintain our view that the MPC will now pause its rate hiking cycle while it assesses the momentum within the economy, particularly in light of the dour economic growth projections. With MPC guidance divided, confidence in our assessment is low, with the Bank themselves pointing out ‘there are risks on both sides of that judgement.’ Therefore, the chances of a fifth consecutive rate increase in June do look finely balanced and another hike should not be ruled out.
Despite the latest economic projections from the Bank, the market-implied interest rate path now shows rates rising to 2.37% within the next twelve months, compared with 2.00% in March, which we continue to view as overly optimistic.
Source: CCLA/Bloomberg.
Impact on deposit funds
Since the start of the year, we have been positioning the investments within our three cash funds to allow for their net yields to quickly react to this new rate environment. Using CCLA’s Public Sector Deposit Fund as an example, within the next seven days 45% of the holdings will have been rolled over at the new higher rates, 54% within a month and 86% in less than three months. Therefore, we should see a relatively quick readjustment in their net yields.
Given the volatility we have witnessed over recent months at the longer end of the curve, we have been reluctant to overextend the funds into these periods, thereby protecting mark to market values in the process.
The CBF Deposit Fund declared rate will increase on Tuesday to 0.80%, by close of business Friday we expect the PSDF net yield to be around the 0.82% level, while the COIF Charities Deposit Fund should be around the 0.72% mark, and we expect a continued upward trend in these yields over the coming weeks and months.