BoE Tells Markets to Keep Hunting the Thimble

Summary

• The Bank of England sees inflation as driven by a supply shock expected to disappear next year.
• The BoE will not hike until the impact of the furlough scheme ending becomes clear, which may not happen until early Q2.
• The BoE sees only limited tightening needed to keep inflation on target.

Pay More Attention to the Data Than the Governor

The Bank of England (BoE) is much less concerned by market reaction to policy changes than the Fed. The Fed is very wary of surprising markets. It typically introduces policy changes through carefully crafted communications ahead of meetings or even through unattributed newspaper sources.

The BoE has no such qualms, and market participants often feel wrongfooted by senior BoE officials’ communications. Such was the case today, and one reporter asked the governor if the BoE was an ‘unreliable boyfriend’.   

From my side of the Atlantic, senior BoE officials wrongfooting markets looks like a pattern. I have often wondered if this was intentional and meant to introduce some uncertainty on the policy outlook. After all, one downside of central bank transparency and extensive communication is that they convey much more certainty about the future than central banks have. Yet market participants crave that certainty because a) the human brain does not like uncertainty, and b) lower uncertainty makes for lower risk premia. So senior BoE officials’ carefully cultivated communication carelessness could be a way to limit market froth.

Regardless, if the data and governor point in opposite directions, following the data seems safer.

The First BoE Hike Is Unlikely in Q2

The BoE told markets today they were not close to finding the thimble. The markets ate forecast was cold – based on market pricing of the policy rate, inflation would be below target but not icy as ‘some modest tightening of monetary policy over the forecast period is likely to be necessary.’

I think the first rate hike is unlikely until Q2 for two reasons. First, unlike the Fed, the BoE is unconcerned about the transitory nature of inflation: it views energy prices and global supply shocks as inflation’s main drivers. Based on energy futures prices, which the BoE uses for its inflation forecast, inflation peaks at 5% in April 2022 and falls thereafter. BoE officials today defined transitory inflation as inflation that did not change behaviours.

The second reason a BoE hike is unlikely until Q2 is that the impact of the end of the Coronavirus Job Retention Scheme (CJRS) could take time to become clear. Governor Andrew Bailey stated, ‘The short-term evolution of the labour market will be crucial in determining the scale and pace of the response. We do not yet have the necessary hard evidence on the state of the labour market following the end of the furlough scheme to make a sufficiently clear assessment.’ For instance, by the time the BoE gears up for the 17 March 2022 MPC meeting, only the December labour market data will be available. Unless the impact of the end of the CJRS is clear early, the BoE will likely prefer to wait.

The BoE further provided guidance on the tightening cycle. Bailey said, ‘I would caution against views on the scale of an increase that would be likely to push inflation below target in future by increasing slack in the economy’. Essentially, the BoE expects the end of the supply shock to lower inflation without much need for monetary policy tightening. During 2017-19, the bank rate rose by 50bp, which could be enough this time or at least for 2022.

Three things could bring forward a rate hike: labour market slack falling faster than the MPR forecast; cost pressures rising faster than in the MPR forecast; weaker aggregate supply/stronger aggregate demand than the MPR forecast.