At its May meeting, the Bank of England’s (BoE) Monetary Policy Committee decided to raise interest rates by 25 basis points (bps) to a 13-year high of 1.00%.
All nine members considered policy tightening to be appropriate given the strength of the labour market and persistence of domestic inflationary pressures. However, three policymakers went one step further and called for a more aggressive 50 bps increase to 1.25% in order to stamp out the risk of “second round” effects.
Updated projections show the BoE now expects the unemployment rate will fall more sharply to 3.5%, the lowest since the early 1970s. This is contributing to a stronger pick-up in wage growth, which is expected to hit 5.8% by the end of the year. But it also now assumes consumer inflation (tracked by the consumer price index) will peak a little over 10% in Q4.
With household incomes set to undergo a more significant squeeze, economic growth is assumed to slow sharply. This comes to a head in Q4, when GDP is forecast to contract by almost 1.0%. Resultantly, the BoE now expects the economy to contract by 0.25% in 2023 after an expansion of almost 4% this year.
Still, the majority of the committee judged that further rate increases would be necessary over the coming months. And now that the policy rate has reached 1.00%, policymakers will consider beginning the process of selling the Bank’s gilt holdings. In this vein, the committee instructed staff at the Bank to prepare a framework for gilt sales in time for its August meeting.
Overall, it was a more hawkish decision than had been anticipated. City economists had expected the same split as the previous meeting, at which eight members called for a 25 bps hike and one voted for no increase at all. What’s more, the projections of the Monetary Policy Committee anticipate that inflation will still be above target in two years’ time. As this is conditioned on market pricing for interest rates, it implies policy would have to be tightened by more than is currently discounted.
While sterling initially broke higher, it has since sold off as investors digested the decision. It has fallen nearly a cent and a half against the US dollar, placing it on course for its biggest daily fall since March 2020. Money markets have effectively taken out one conventional hike for this year, such that they now expect the policy rate to be closer to 2.00% by the end of 2022.
We still view market pricing to be overextended. Concerns amongst the committee about inflation becoming embedded are justified. But we also believe that near-term economic momentum is more fragile than it has concluded. Further hikes will hinge on how the data evolves over the coming months. In particular, whether the deterioration in consumer confidence sees spending scaled back.
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.