Monex Europe: The end is nigh for the BoE’s tightening cycle

3 augustus 2023

The Bank of England today voted 1-6-2 to hike Bank Rate 25bps to 5.25%, marking a deceleration in its hiking cycle after June’s surprising 50bp increase.

Unsurprisingly, Swathi Dhingra is now the sole dove voting to hold rates amongst the Monetary Policy Committee (MPC) following the exit of Silvana Tenreyro, while Catherine Mann and Jonathan Haskel both continued to sit on the more hawkish side of the spectrum, dissenting with the view of a 50bp hike.

While the decision met our forecast and the prevailing consensus amongst market participants and economists, there was a tail risk that the BoE would raise rates by a further 50 basis points. Markets priced this at around 30%.

This tail risk reflected the fact that, while there are early signs that the labour market is cooling and inflation pressures are beginning to moderate on the whole, the BoE has consistently been too optimistic on this manifesting within the hard data and at present little progress had been made in services inflation and wage growth – the strength of  which prompted the 50bp hike back in June in the first place. This case was set out by both Catherine Mann and Jonathan Haskel, resulting in their hawkish dissent as they voted for a successive 50bp 'hedge' against these risks.

Despite this compelling case, however, the core of the MPC decided to take a more forward-looking position once again, noting the positive developments in the data that have taken place since the May decision. This was ultimately reflected in their inflation projections, which now see fewer upside risks over the medium-term and generally point to the fact that monetary policy is close to its terminal level.

In conjunction with the inclusion of the phrase that 'the MPC will ensure that Bank Rate is sufficiently restrictive for sufficiently long to return inflation to the 2% target', we view today’s decision as confirmation that the BoE is likely to end its hiking cycle in September at a terminal rate of 5.5%, based upon the current trajectory of the data.

After this point, we believe further monetary tightening will be delivered through the duration in which rates are held at this level and through the reduction of the Bank’s balance sheet. On the target reduction in the gilt stock for the 12-months to October 2023, the Bank has withheld its decision until September’s meeting, where we expect the overall reduction to be increased from £80bn to £90bn.

Today’s decision has driven markets to bend further towards our implied path for the Bank of England and in doing so has brought GBPUSD towards our month-end forecast of 1.26.

Over the near-term, we expect more dovish expectations for the BoE’s policy path to restrict any upside in sterling given the currency’s sensitivity to rate differentials, but note that the balance of risks is tilted to the upside should private sector wage and services inflation data continue to show resiliency and the need for a higher terminal rate.

In the absence of these risks materialising, we expect sterling to become less sensitive to UK rates specifically given the BoE is likely to embark on a sustained period of inaction. 

Sterling falls alongside terminal rate expectations for the BoE

BoE forecasts suggest terminal rate is close 

The Bank of England has recently de-emphasised the importance of its inflation projections in setting monetary policy given the repeated forecast errors year-to-date, leading them to recently sanction a forecast review spearheaded by former Fed Chair and Nobel Prize-winning economist Ben Bernanke.

Nevertheless, with the Bank of England’s reaction function now becoming more forward looking, the illustrative forecasts should be viewed once again with more credence. This is increasingly the case given headline inflation has returned to the Bank’s previous projections and the latest round of forecasts now incorporate a greater subjective assessment of inflation persistence, thus reducing the potential forecast error in the future. 

Different paths, same destination: Bank of England’s market-implied and constant rate projections suggest Bank Rate is close to its terminal rate 

Under the Bank’s latest estimates, the modal projection for headline inflation in two years’ time is 1.7% irrespective of whether this is conditioned on a constant Bank Rate of 5.25% or a market path that sees a peak of 6.12% in Q2 and then a decline to 5.2% by the end of the projection horizon.

Furthermore, when factoring in the upside risks that remain to these forecasts, the mean inflation projection is still 2% for two-years’ time, in line with the BoE’s target. After which, the average projection sees inflation falling to 1.9%. In summary, the greater confidence the BoE has that policy is currently calibrated at a sufficiently restrictive level suggests that the end of the hiking cycle is near.

However, owing to continued uncertainty over the true level of inflation persistence, we expect the Bank to hedge against resurgent inflation pressures with a further hike in September to 5.5% before stressing that policy is likely to stay at this level for an extended period of time.

We think this is a more optimal path for the BoE to take relative to that of a higher peak and subsequent cuts, previously implied by markets, given it is easier to communicate and reduces overall financial stability risks.

While one more rate increase in Q4 is still viable, we believe the Bank will need to see a further crystallisation of inflation persistence in the wage data for this to take place. However, we note that the risks of this materialising are now lower given the Bank’s upward revision to its services inflation forecast. 

BoE significantly revised up its estimate of services inflation in August, reducing the scope for future positive surprises