Bank of England to increase rates to new 15-year high

The Bank of England will not be stopped from raising interest rates this week to a new 15-year-high, but the signs that UK inflation has finally cooled could allow the rate-setters slow down the pace of tightening.

After months of disappointing statistics, a sharp drop to 7.9% in consumer price inflation for June raised hopes that UK policymakers would finally succeed in their battle to restore price stability.

Investors bet that, ahead of the release of the data, the BoE will need to raise the Bank Rate rapidly from its current 5 percent level to well over 6 percent to bring inflation back to the 2 percent target. There is a growing hope that the tightening cycle of the Federal Reserve, the European Central Bank and UK policymakers could be coming to an end. Even in the UK where rates have remained at high levels, market pricing indicates that rates are likely to peak below six per cent.

The BoE’s next policy decision is on a razor-thin edge. Investors see an increase of 0.25 percentage points as more likely, but still believe there is a good chance that the rate will rise by 0.5 percentage points for a second time.

Thomas Pugh is an economist with RSM UK. He said that the economy was clearly too hot to allow the Monetary Policy Committee (MPC) to relax. While the slowdown of inflation could “tip” the balance towards a rise of 25 basis points, he added that “inflation remains far from being under control”.

The MPC said that when it met last in June it would closely examine the tightness of the labour market, wage growth, and inflation of services prices. If they pointed to “more persisting” inflationary pressures then “further tightening of monetary policy will be required”. Since then, the evidence has been mixed. Services inflation has dropped, but less than the MPC was expecting when it last published forecasts in May.

The labour market is showing signs of a slowdown, as unemployment continues to rise, the number of vacancies drops and the workforce begins to grow. The wage growth rate has reached record levels, and is now one of the major drivers of service inflation.

Cathal Kennedy is a senior UK economist with RBC Capital Markets. He said that these data could be used to support either a 25 or 50 basis-point [increase]. He predicted that the nine-member committee would be divided, with a majority voting for a slower pace of tightening and a hawkish group favouring a rise in rates by 50 basis points, while the dovish Swati Dhingra voted to keep the rate on hold.

Andrew Goodwin of Oxford Economics is one of the economists who expect a lower rate increase. He argues that the change in the market expectations “gives MPC cover to dial down”. But Dave Ramsden, the only member of the MPC who has spoken publicly since the latest inflation data, struck a hawkish note, saying earlier this month that inflation “remains much too high” and underlining the MPC’s resolve to “address the risk of more persistent strength in domestic wage and price setting”.

The committee will face a difficult task if it wants to continue tightening the policy. This is because the forecasts that it will provide alongside its rate decision will likely show that GDP and inflation are expected to be lower in the medium-term than they anticipated in May.

The predictions are based upon the market’s expectations of the interest rate path over a two-week period in mid-July, when rates were much higher than the current prices and higher than they were in May. The sterling has also strengthened in comparison to May while wholesale gas prices are down.

The forecasts will likely show that inflation will fall below the 2 percent target in the next two to three years.

Samuel Tombs of Pantheon Macroeconomics said that the new MPC forecasts would cast doubts on whether rates should be raised further.

The MPC played down the importance of such contradictory messages in its forecasts during previous meetings. It now places more weight on the judgment of its risk assessment of its central projection.

Philip Shaw, an economist with Investec, said that the committee is no longer relying on forecasting models but instead putting more emphasis on risk and judgment.

The BoE, after repeatedly failing to forecast the persistence of inflation has launched a review of its forecasting processes, to be led the former Fed Chair Ben Bernanke.

Capital Economics’ Paul Dales said that the BoE would “leave open the door to further rate increases” if later data warranted it.

Matthew Swannell is an economist with BNP Paribas and he offers another reason for the MPC to act now rather than wait.

He said that the BoE had a limited amount of time before it became an international outlier. Both the Fed and ECB, he argued, could have raised rates by September.

“With this in mind, the BoE has only a few opportunities to tighten the rates without becoming last hawk left standing.”