The Bank of England (BoE) met today and raised its key policy rate by a quarter percentage point for the fifth time in a row, to 1.25%.
The tightening of economic conditions follows a 40-year high in inflation, reaching 9% in April.
This is forecast to rise even further to 11% on increased energy tariffs this coming winter.
This is the first time since 1997 that policy rates have been raised in five consecutive meetings, signaling the urgency of the situation the BoE finds itself in.
Monetary tightening is set to continue and the BoE announced that more aggressive rate hikes may be necessary to bring down costs. However, anemic growth projections and GDP contractions will limit the BoE’s ability to hike.
The key drivers of high inflation were the usual suspects, energy, and food.
The BoE concluded that “energy and core goods inflation… account for around 80% of the overshoot of CPI inflation”.
Inflation in the UK is caused largely by domestic inefficiencies and bottlenecks, amid a tight labor market, strong labor demand, and a high number of retirees.
Despite this, real wages have buckled 3.5% over the past three months.
Of particular concern to the BoE is the possibility of a wage-price spiral.
In a tight labor market, workers demand more wages, driving up both production costs and spending power, leading to more inflation.
Once such spirals emerge, monetary authorities find it very difficult to manage prices, a problem that would be even more challenging with the UK’s growth constraints.
Food prices are forecast to top 15% later this year and will be a significant source of hardship for many households. The BoE points to the rise in crude oil prices to trade routinely above the $120 mark. Global food shortages have also been exacerbated due to the Ukraine-Russia war.
Mortgage rates have continued to increase in line with higher rates, and will likely price many individuals out of the housing market, especially those on variable rate packages.
Forced to be gradual
The BoE has been forced to take a much more gradual approach to raise rates than the Fed, despite raging inflation.
The BoE is constrained by the fragility of the economy which is expected to contract 0.3% during Q2.
In March and April, monthly GDP had contracted by 0.1% and 0.3%, respectively.
According to the OECD, the UK is expected to grow at 0% through 2023, the lowest among the advanced countries, save Russia. A looming trade battle with the EU does not help its prospects.
Tightening credit too fast in this scenario will likely lead to many foreclosures, and defaults among small businesses, further dampening growth prospects.
Cracks began to show in the BoE, with the decision being passed 6-3, with the three dissenting members advocating a 50-bps hike during the meeting, as in the previous meeting. The 6 members including Governor Andrew Bailey who voted for the quarter-percent hike were concerned that demand signals may already be slowing.
In terms of shrinking the balance sheet, the BoE will not be re-investing £3.2 billion received from gilt redemptions, while 10-year government bond yields have risen by over half a percent since the previous meeting.
What Next?
The BoE has signaled that it “will if necessary act forcefully,” during its next meeting, in case inflationary pressures fail to show signs of abating.
Due to the ongoing Russia-Ukraine war and associated supply chain disruptions, high inflation will likely persist.
The BoE would then look to accelerate policy normalization with a half percentage rate hike.
In such a case, conditions would prove to be very difficult for the UK’s growing retiree population.
The BoE also reported that businesses expect output price inflation to have risen by 5.9% on an annual basis, in the three months to May, suggesting that inflation expectations continue to rise through the rate hike cycle.
The UK economy is on a razor edge, with stagflationary scenarios entirely possible if rate hikes are front-loaded by the BoE.
Source: BoE
The BoE noted that “Monetary policy will ensure that… CPI inflation will return to the 2% target sustainably in the medium term.”
With low growth projected, and global stock exchanges returning much of the gains achieved post the Fed’s 75 bps hike yesterday, a softish landing seems highly improbable despite the BoE’s confident rhetoric.
By hiking rates into a fragile economy, a recession or worse could certainly be on the cards.
The Swiss Hike
At the same time, inflation is picking up globally, with the decision by the Swiss National Bank to raise rates from -0.75% to -0.25%, earlier today. This was the first rate hike in fifteen years by the bank. In a statement, monetary authorities admitted that further rate hikes will be on the cards.
Jane Foley, head of FX strategy at Rabobank said that “The SNB move comes as a big shock.”
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