Bank of England to Rebuff Hawkish Market Pricing

Summary

• The BoE may still undergo a nuanced dovish pivot in November despite the recent hawkish shift among MPC members.
• There are three reasons: fiscal stimulus is being reversed; inflation expectations look relatively anchored; labour market tightness could reverse.

Market Implications

• We expect a 75-100bp hike in November but resistance against the market pricing of a peak bank rate above 5%.

The recent fiscal event (the mini-Budget) has prompted a change at the Bank of England (BoE). Since its release on 23 September, the traditionally more neutral members of the Monetary Policy Committee (MPC) have turned more hawkish in their comments (Chart 1).

We had previously expected a dovish pivot in November, but is that outcome now dead? In short, no. But the form it takes may be more nuanced.

Why is the MPC Getting More Hawkish?

Deputy Governor Dave Ramsden, and External Members Jonathan Haskel and Catherine Mann are the three more hawkish members. Among them, the reasons for wanting to hike quickly are as follows:

1. High inflation expectations point towards second-round effects.
2. A low unemployment rate will keep wage growth high.
3. The fiscal expansion will add to medium-term inflation.

This final point is why the more neutral members (Governor Andrew Bailey, Chief Economist Huw Pill and Deputy Governor Ben Broadbent) have moved towards supporting an acceleration in hikes.

Broadbent summarised the rationale best at his speech last Thursday. Pre-fiscal event, the feedthrough from imported inflation (energy, etc.) into medium-term inflation was unclear. So, the BoE took a gradual approach. But the massive consumer support from the fiscal package – £30bn from the energy price guarantee (EPG) alone – will raise aggregate demand. And the BoE’s tools can counter demand, hence a need to raise rates more.

So Why Expect a Dovish Pivot?

Fiscal Policy Is Being Reduced

Since ex-Chancellor Kwasi Kwarteng’s initial fiscal event, many of the policies have been pared back. Most importantly, the EPG’s future after the first six months is yet to be confirmed (Charts 2 and 3).

The BoE bases forecasts on policy. It can no longer assume the c.£30bn of support previously guided out to 2023/24 will be made available. More likely, a more targeted, less expansive policy will be introduced later.

Inflation Expectations May Be Relatively Anchored

The hawks (especially Mann) believe inflation expectations are de-anchoring. They think if businesses and consumers start to expect higher inflation as the new norm, they will raise prices faster, ask for more pay, etc. This will compound price pressures, and, they believe, requires strong hikes in response.

However, market pricing for medium-term inflation has been trending down for a while (Chart 4). And consumer expectations look to have levelled off.

True, business expectations have shot higher. However, (as ever) there is nuance to the survey readings. While their estimates of CPI (in Chart 4) have rocketed, their expectations for their own price setting have levelled off (Chart 5). Perhaps this means businesses see their own margins getting squeezed more than others’, or that their own power to raise prices is reaching its limits. Either way, it suggests their 3Y ahead CPI forecast should be taken with a grain of salt.

Labour Market Tightness May Reverse

The UK unemployment rate is currently 3.5% – it’s lowest rate since 1974. However, that is due more to labour force shrinkage than employment growth. The unemployment rate is those without a job actively seeking work divided by the size of the labour force. So, when individuals drop out of the labour force (i.e. become ‘inactive’), it forces the unemployment rate down.

We can see this clearly. Since before the pandemic, the number of employed people is slightly down. The total working-age population is roughly flat. The greatest change has been the rise in the number of inactive people due to sickness (Chart 6).

This phenomenon predates COVID – it began in early 2019 (Chart 7). Albeit extremely rapid, the recent rise only returns it to late 1990s levels.

Yet the labour market tightness could reverse.

Firstly, the labour market inactivity rate tends to correlate with inverse savings rate, which is already rising (Chart 8). When peoples’ savings grow more slowly, they are more incentivized to find work. This is a huge negative for consumers and people who would otherwise prefer not to work (the sick, carers, students, the retired, etc.).

Meanwhile, the negative economic outlook is feeding into firms’ hiring intentions (Chart 9). This suggests less job creation ahead.

What Is the Market Pricing?

So the main pillars supporting hawkishness may be starting to turn. The market, however, has continued to add to its pricing for bank hikes (see our Explainer on how markets price the BoE).

Broadbent, in his speech, mapped out the ‘optimal’ (that is, highly theoretical) amount of additional tightening required on the back of the fiscal event. Along with the depreciation in GBP at that time, it suggested c.75bp of additional hikes.

The market added much more than that (c.150bp). And even after the paring of fiscal stimulus and restrengthening in GBP, market pricing sits 75bp higher than pre-fiscal event (Chart 10). And significantly above the upper range of where I forecast a reasonable path to be.

The Impact on Mortgages

So why does the BoE care what is priced? The tightening the market is pricing two years out from now appears as a rise in the short end of the swaps curve. This, in turn, drives current pricing for mortgages (Chart 11).

Come the next monetary policy report in November, the high market pricing of bank rate will throw BoE forecasts off entirely. Broadbent estimates that at their peak (c.6.5% terminal rate), hiking in such a manner would knock 5% off the UK economy by 2025.

How Might the BoE Play It?

The obvious way for the BoE to play it then is to hike strongly (75bp likely, maybe even 100bp), but push back against market pricing of the terminal rate. That would offset some of the pain to consumers from the mortgage rate and allow for a more realistic forecast for them to base their policy on.

In such an outturn, despite a strong rise in current rates, the market would probably take the move as dovish. It would be expected to suppress short-term rates, and provide some respite to the more short-term rate and mortgage rate exposed parts of the economy.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)