The Bank of England is on the horns of a dilemma as the UK economy continues to struggle with double digit inflation, although it may not be as bad as was thought at the end of 2022.
Analysts are predicting interest rate moves of between 25 and 50 basis points when the BoE and ECB meet separately on 2 February – but will it be what we expect?
The slide in energy prices in recent months has alleviated some of the pressure on wage packets when it comes to petrol prices. However, with food price inflation still at 16%, “the BoE will need to also be acutely aware that a weak pound will make headline inflation much stickier than it needs to be if it shows any indication that it’s going soft when it comes to hitting its inflation target”, comments Michael Hewson, chief market analyst at CMC Markets.
There will be the usual concerns about the impact on mortgage costs from another 50bps move. 5-year gilt yields have barely moved since the lows set back in November, although 2-year yields are currently higher. We may see a split again, with Tenreyro and Dhingra likely to be the most averse to another hike, given that they voted for no change in December. The likes of Catherine Mann are likely to push for another 50bps, while the rest of the committee are expected to split between 25bps and 50bps from the current 3.5%.
“Whatever we get from the Monetary Policy Committee is unlikely to help the pound in the short term, given the Bank of England’s propensity to talk the pound lower whenever they meet”, Hewson has suggested.
The low interest rate environment, along with various fiscal stimulus programs implemented by governments and supply chain disruptions wrought by the Covid-19 pandemic already pushed headline CPI in the UK to 6.2% in February 2022. This was over 3 times higher than the Bank of England’s inflation target, which occurred even before Russia’s invasion of Ukraine.
There’s a risk that this current inflation slowdown could be transitory itself, with headline inflation stabilising at current levels, thus necessitating rates being higher for longer.
If we look elsewhere, we can see that inflation is not only higher, but it’s also stickier. In the UK, it’s still in double digits, while in the EU, it has only just fallen below 10% as of January 2023.
Can the ECB return inflation to its 2% goal?
“When it comes to the European Central Bank, it seems more than likely that we’ll see another 50bps rate hike this week, with a raft of ECB governing council members coming out more aggressively in favour of multiple 50bps rate hikes in the coming months”, Hewson has predicted.
ECB President Christine Lagarde doubled down on this perception in the wake of the Davos Economic forum, stating that inflation is still too high, and that markets are underestimating the ECB’s resolve to drive prices back towards their 2% inflation target.
While the ECB did step down to a 50bps hike in December, there were several members on the governing council who wanted another 75bps hike. These are still pushing even as headline inflation in the euro area falls back below 10%. When the ECB met in December, Lagarde pre-committed to at least another three 50bps rate hikes at the next 3 meetings, in a move that has seen the euro push higher, but so far has failed to see it follow through.
“This would suggest that markets are unconvinced the ECB will be able to follow through on such guidance, given the risks it might pose to the borrowing costs of the more highly indebted members of the euro area”, states Hewson.