At the beginning of February, the Bank of England’s (BoE’s) Monetary Policy Committee (MPC) decided to increase the base interest rate by 50 basis points (bps) to 4% – the highest interest rates have been for more than a decade.
Simultaneously, the BoE gave its strongest indication that the base rate was close to peaking when it said that further hikes would only occur if there was “evidence of more persistent [inflationary] pressures”.
Two weeks on from that decision, the Office for National Statistics (ONS) released the UK’s latest Consumer Price Index data, which revealed that the rate of inflation slowed by 0.4% in January, taking it to its lowest level for five months. Despite remaining in double figures – 10.1% to be exact – many analysts have suggested that February’s rate hike could be the last, since inflation fell more sharply than expected.
That said, when compared with other major economies, the UK is uniquely exposed to inflationary price pressures, while wage growth is increasing at its fastest rate for more than two decades. Meanwhile, with the UK set to be the only major economy to shrink in 2023, economic growth is being strangled by the BoE’s battle with inflation.
As such, concerns are growing that the BoE is risking a deeper recession than is necessary to cool the economy, leaving many investors wondering: what will the MPC do next?
Controlling inflation still a priority
Obviously, as inflation print is more than five times higher than the BoE’s target of 2%, inflationary pressures will continue to be the BoE’s main focus. So, despite inflation dipping in January, what pressures remain?
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With ONS data showing that 26.7% of inflation is being caused by energy costs, this is likely to be a topic of discussion at the MPC’s next meeting. Although wholesale prices have receded in recent months, prices for consumers remain elevated and will continue to fuel inflation, should the drop in price not be passed on to consumers. Ultimately, this could force the BoE into further interest rate hikes.
Similarly, the labour market has become an increasingly important metric for the direction of the economy and inflation. For much of 2022, BoE governor Andrew Bailey and fellow MPC members blamed a shortage of workers for the upwards pressure on wages. Therefore, with vacancies declining recently, investors would be forgiven for feeling a sense of optimism as this inflationary pressure begins to fall away.
The data, however, tells a different story. Q4 2022’s average earnings statistics showed an increase of 6.7% compared with the same period in 2021. If such dramatic wage growth continues, there is a real risk that wages and prices start to spiral, and inflation becomes even more entrenched. Consequently, the argument for another rate hike looks to be increasingly pertinent, despite the short to medium-term pressure it will place on consumers’ finances.
Finally, the lasting impact of the government’s pandemic fiscal packages muddies the waters further for the MPC. Combined with an uptick in personal savings, the furlough and Eat Out to Help Out schemes left consumers with plenty of disposable income when society reopened after the various lockdowns. Rising discretionary purchases meant that the economy recovered quickly – however, crumbling supply chains and bottlenecks led to a sharp uptick in prices.
A balance must be struck with economic growth
In the short term, inflation must be stamped out. However, the effects of tightening the economy too much could be disastrous for its long-term health. Therefore, the BoE will be focused on balancing its battle with inflation with economic growth.
Already, the UK is teetering on the edge of a recession. In Q4 2022, for instance, gross domestic product saw a dip of 0.5% in December, while Q3 saw the economy shrink by 0.2%. For the IMF, the economy will contract again in 2023 and finish the year as the worst-performing major economy (heavily sanctioned Russia included). With growth stumbling, further hikes could push the economy into a recession that it miraculously avoided in 2022.
Where does the BoE go from here?
Market expectations see the BoE hiking the base rate again in 2023. A 4.5% peak in the summer has been priced in already, while many expect rates to be cut in the first few months of 2024. Despite this, the BoE has a difficult decision to make at the next MPC meeting.
For MPC members who are worried about limiting economic growth too much, January’s inflation print gently supports their calls to pause the rate hikes in the hope that inflation has peaked. As a result, some economists are forecasting a lower peak for interest rates at 4.25%. Indeed, short-term interest rate markets suggest that there is a one-in-ten chance that the BoE will hit pause in March. If this were to occur, a 25bps rate cut in Q4 this year would not be outside the realms of possibility.
However, for the more hawkish members of the MPC – such as BoE policymaker Catherine Mann – there are still “material upside risks” for sticky inflation. As such, to protect the long-term health of the UK economy, further hikes are needed to grind inflation into the ground. However, this would be a bitter pill for many consumers, businesses and investors to swallow, and could exacerbate the impending economic slowdown.
As the markets have already priced in another rate hike, it is likely that the BoE will want to capitalise on the downward trend for inflation and raise rates one more time to try and curb inflation for good. After that, however, it would be wise to pause the hiking cycle, allowing the economy to adjust to the new normal of higher interest rates, and to allow growth to flourish.
Opportunities remain for investors
The actions of the Federal Reserve and the other major central banks should be front and centre in the minds of investors in the coming months as the global economy tries to combat inflation. For most major economies, further interest rate hikes are the most likely option. As such, the speed at which these economies’ central banks hike, cut or pause their interest rate hiking cycles could create a great deal of currency volatility in the foreign exchange markets, which can only be a good thing for investors.
At the moment, it is too early to tell whether we have won the battle against inflation. With inflation inflicting significant damage on all areas of the UK economy, it would be hard to argue for anything other than one further interest rate hike to stamp it out.