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Bank of England Is Right to Take a Softly, Softly Approach on Rates

Andrew Bailey, governor of the Bank of England (BOE), during the Monetary Policy Report news conference at the bank’s headquarters in the City of London, UK, on Thursday, Aug. 4, 2022. The Bank of England unleashed its biggest interest-rate hike in 27 years as it warned the UK is heading for more than a year of recession under the weight of soaring inflation.
Andrew Bailey, governor of the Bank of England (BOE), during the Monetary Policy Report news conference at the bank’s headquarters in the City of London, UK, on Thursday, Aug. 4, 2022. The Bank of England unleashed its biggest interest-rate hike in 27 years as it warned the UK is heading for more than a year of recession under the weight of soaring inflation. (Bloomberg)

The Bank of England acted cautiously by raising its official rate by 50 basis points to 2.25% on Thursday. However, that doesn’t mean it won’t step up the pace at its next quarterly economic review on Nov. 3, as it has made clear its determination to wrestle runaway inflation down to its 2% target. The global rate-hiking cycle is far from over, as the Federal Reserve illustrated on Wednesday with its third consecutive 75 basis-point jump.

With three of the nine members of the Monetary Policy Committee voting for a larger 75 basis-point hike, it won’t take much bad inflation news to prompt a more aggressive move from the BOE next time. For now, caution is warranted.

In the world we live in a half-point hike is now considered dovish, with its central banking peers — especially its neighbor the European Central Bank — taking three-quarter point leaps. But the UK is a more open and interest-rate sensitive economy. Moreover, the BOE is not in possession of the full facts about the government’s impending plans to deliver a fiscal boost.

Sterling was little changed to the dollar, remaining close to its lowest level since 1985. On a trade-weighted basis the value of the pound has fallen 10% in the past year, back toward the pandemic lows of March 2020. Ten-year gilt yields similarly barely reacted, but remain close to the highest levels since 2014 and treble where they started this year. Sterling money markets are pricing in a peak of rates at 5% by the middle of next year, although that is considerably higher than most economists expect. Bloomberg Economics looks for 3.75% by the summer of next year, with no rate cuts until 2024.

This more measured approach illustrates that the BOE is treading a finer line, compared with the Fed and ECB, in assessing the economic impact of rapidly escalating borrowing costs. Bloomberg Economics Senior Economist Dan Hanson suggests that “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.” The BOE now expects inflation to peak at just under 11% in October, though it may stay above 10% for several months. That may mean interest rates stay higher for longer if the BOE assesses that a more generous fiscal policy will lead to increased consumer spending, although the BOE’s statement did flag up evidence from its agents that retail activity and underlying growth may be starting to slow down.   

Chancellor of the Exchequer Kwasi Kwarteng is due to unveil his plan for growth on Friday, which should give clearer direction on the size of the fiscal largesse the government is preparing to dispense to lift the UK economy. The BOE will need to analyze carefully how stimulatory these measures might be, to calibrate how much further monetary policy needs to be tightened to counteract rising inflation expectations.

Courtesy of the government’s promised spending splurge, the BOE will likely amend upwards its growth outlook at its November review. In August, somewhat controversially, its forecasts mapped out a five-quarter long recession. Nonetheless, the risks of a mild technical recession remain for either this year or next.

Another reason for the BOE refraining from ever larger rate hikes is its dual approach to tightening financial conditions. The Monetary Policy Committee is stepping up the reduction of its quantitative easing bond pot. Direct sales back into the gilt market will commence next month, in addition to maturing holdings not being reinvested.

This will double the annual attrition rate to £80 billion ($90 billion), as the BOE seeks to reduce its £838 billion of holdings. The gilt market should be able to take this is in its stride. Many of the BOE’s holdings are in bonds that are in short supply, so it could improve overall liquidity, if deftly arranged not to clash with new issuance from the government.

There is one important caveat to this, which is how much the overall scale of gilt sales is raised over the rest of the fiscal year. This will be announced when Kwarteng finishes his fiscal statement on Friday. An increase of around £60 billion, lifting the full-year total to £190 billion, is expected, but the distribution in maturities is also important as there has been a noticeable lack of issuance in shorter-dated debt in recent years.

Issuance for the next fiscal year, starting in April 2023, could rise by as much as £100 billion, but details of that will not known until the November budget at the earliest, in combination with new set of financial forecasts from the Office for Budget Responsibility.

There are a lot of moving parts for the BOE to digest, not only how the economy is reacting to its rate-hiking pace, but also the sudden political switch to looser fiscal policy from the previous government’s more parsimonious approach. The MPC will be keen not to be viewed as taking its eye off the inflation ball. Thursday’s more considered approach doesn’t mean that the peak in rates will be either lower, or reached earlier. UK monetary policy remains very much a work in progress.

More From Bloomberg Opinion:

Fed Splits the Difference on Labor Market Pain: Jonathan Levin

Fed Must Show It’s Willing to Cause a Recession: Editorial

• Truss Faces Four Hurdles to Spur Growth in UK: Mohamed El-Erian

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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