Could UK economy be more fragile than BoE believes?

At its May meeting, the Bank of England’s (BoE) Monetary Policy Committee decided to raise interest rates by 25 basis points (bps) to a 13-year high of 1.00%.

All nine members considered policy tightening to be appropriate given the strength of the labour market and persistence of domestic inflationary pressures. However, three policymakers went one step further and called for a more aggressive 50 bps increase to 1.25% in order to stamp out the risk of “second round” effects.

Updated projections show the BoE now expects the unemployment rate will fall more sharply to 3.5%, the lowest since the early 1970s. This is contributing to a stronger pick-up in wage growth, which is expected to hit 5.8% by the end of the year. But it also now assumes consumer inflation (tracked by the consumer price index) will peak a little over 10% in Q4.

With household incomes set to undergo a more significant squeeze, economic growth is assumed to slow sharply. This comes to a head in Q4, when GDP is forecast to contract by almost 1.0%. Resultantly, the BoE now expects the economy to contract by 0.25% in 2023 after an expansion of almost 4% this year.

Still, the majority of the committee judged that further rate increases would be necessary over the coming months. And now that the policy rate has reached 1.00%, policymakers will consider beginning the process of selling the Bank's gilt holdings. In this vein, the committee instructed staff at the Bank to prepare a framework for gilt sales in time for its August meeting.

Overall, it was a more hawkish decision than had been anticipated. City economists had expected the same split as the previous meeting, at which eight members called for a 25 bps hike and one voted for no increase at all. What's more, the projections of the Monetary Policy Committee anticipate that inflation will still be above target in two years’ time. As this is conditioned on market pricing for interest rates, it implies policy would have to be tightened by more than is currently discounted.

While sterling initially broke higher, it has since sold off as investors digested the decision. It has fallen nearly a cent and a half against the US dollar, placing it on course for its biggest daily fall since March 2020. Money markets have effectively taken out one conventional hike for this year, such that they now expect the policy rate to be closer to 2.00% by the end of 2022.

Market pricing stills seems to be overextended. Concerns amongst the committee about inflation becoming embedded are justified and near-term economic momentum may be more fragile than it has concluded. Further hikes will hinge on how the data evolves over the coming months. In particular, whether the deterioration in consumer confidence sees spending scaled back.

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