Hawkish Bank of England plays ‘catch-up’ with the cycle

A 25bp hike was already in the price ahead of February’s meeting and the MPC did not disappoint, paving the way for ‘passive QT’ as the policy rate has now reached the 0.50% threshold for allowing maturing gilts to roll off.

A hawkish hike. The MPC had already shown its true colours back in December when it hiked Bank Rate despite the jump in macro uncertainty brought on by the Omicron variant. This time, the Committee voted by a majority of 5-4, but only because the minority preferred a 50bp increase – consistent with the message that “some further modest tightening in monetary policy is likely to be appropriate in the coming months”.

The MPC is hedging against a highly uncertain future path for inflation – particularly as a lot depends on imported energy and tradable goods prices. The Committee is effectively ‘assuming the worst’ for wholesale energy costs, penciling in steady prices beyond the next six months despite the futures curves sloping downwards.

But the hawkish tone ultimately reflects policymakers’ desire to catch-up with the macro cycle. While in the post-meeting press conference Governor Bailey said that this is “not an inevitable march upwards” in interest rates, our sense is that at this stage the Committee is keen to bring monetary settings closer in line with how far the UK economy has come since the depths of the pandemic.

At this juncture, we think BoE action is best understood as overdue policy normalization that makes sense regardless of the jump in inflation, not as a tightening of financial conditions that will stifle economic activity. In other words, there is still room to adjust policy without fearing that this will bring about a ‘policy mistake’: interest rates remain very low (especially in real terms) and the Bank’s balance sheet is double its pre-pandemic size.

The Committee’s playbook in terms of the desired mix of policy instruments to deliver tighter policy remains the same. Bank Rate is the primary policy tool, and the coming reduction in the stock of gilts is intended to be as close to ‘watching paint dry’ as it comes. After the Fed’s 2018 QT experience, policymakers have become more attuned to the financial system’s demand for reserves. It is no surprise that in recent months Bank officials have taken pains to explain that a smaller stock of gilts does not necessarily translate to a contraction in the BoE’s balance sheet of the same magnitude: as QE unwinds, some of the maturing gilts could be replaced with shorter-term repos and/or other open-market operations. We expect ‘passive QT’ to kick in this spring, taking the Bank’s stock of gilts down to around £840bn by yearend.

Policymakers are on high alert for ‘second-round’ price effects taking hold as inflationary pressures broaden while the surveys show price and pay expectations pointing up against the backdrop of receding Covid fears and a tight labour market. Although the persistence of high inflation is largely supply-driven, the central bank can still ‘do its part’ by switching to a stance that stimulates demand less.

The economy is slowing, however, as the tailwinds behind household spending start to fade. The mix of fast-rising living costs with tax increases, higher borrowing rates and cooling (albeit still solid) pay growth is already weighing on consumer confidence, posing downside risks for private demand – not least as a capex revival is not yet around the corner. Consumer price pressures can also be expected to moderate going into 2022 H2 as global goods inflation likely reverses course.

We therefore still expect a total of two or three rate hikes in 2022 that lift Bank Rate to 0.75-1.0%. This is less than what the market is pricing in. We take the MPC’s inflation forecast of 1.6% three years out as a signal that the Committee, too, thinks market expectations have gone a bit too far – although for the time being it also looks unlikely that officials will actively lean against those expectations. The main risk to our thesis is that inflationary pressures do not abate meaningfully in 2022 H2, fueling higher price/wage expectations and forcing the MPC to tap on the brakes too hard. Not our base case, but something to look out for.