Bank of England interest rate expectations have surged after some unwanted inflation and wage growth data, but economists think the market pricing is wrong.
Today’s inflation data showed the headline consumer price index (CPI) rose 8.7% in May compared to a year ago, unchanged on the previous month, while it had been expected to fall to 8.3% by the Bank's monetary policy committee (MPC) and 8.4% by City economists.
Core CPI, which excludes normally more volatile factors such as food and fuel, rose to a 31-year high of 7.1%.
The UK base rate is currently 4.5% after the MPC hiked by a quarter of a percentage point at the meeting in May.
Markets and some economists are now factoring in a strong chance of a 50 basis points (bps) hike by the Bank of England tomorrow to 5.0%. Prior to today, economists expected a 25bps hike to 4.75%.
Lifting interest rates to 5% would be the highest level since early 2008.
Markets currently are pricing in roughly a 60% chance that rates will increase to a peak of almost 6% for this winter and that a first interest rate cut will arrive in summer next year, around June.
Are expectations wrong?
Market expectations, based on overnight index swap rates, are higher than those of economists.
"May’s CPI figures ratchet up the pressure on the MPC to increase Bank Rate substantially further over the coming months, though we still think the committee will keep to a 25bps increase tomorrow, rather than switch back to a 50bps hike," said economist Sam Tombs at Pantheon Macroeconomics.
He had been forecasting that headline CPI would fall to 8.5% but remained confident it will fall sharply over the remainder of this year, "probably to about 4.5% by December and to around 2.0% in the second half of 2024".
All told, despite CPI not falling as much as he expects so far, Tombs said he continues to think that the MPC will not raise the interest rate to the near-6.00%.
Similarly, Holger Schmieding, chief economist at Berenberg, said "the market pricing looks too high to us".
As the UK has more fixed-interest mortgages, the pass-through of monetary policy to consumption via the housing market takes longer than in the past.
"But it will still happen, in our view," he said. "This highlights the risk that, if the BoE overreacts to near-term inflation surprises, it may set the stage for an inflation undershoot once the full effects of its prior policy decisions play out."
Capital Economics is among those forecasting the MPC will hike to 5.00% at tomorrow’s meeting.
A bigger concern than CPI remaining unchanged, said chief economist Neil Shearing, is that core inflation rose yet again.
"This marks the UK out from other advanced economies, including the euro-zone and the US, where core inflation has started to fall."
With markets expecting a 50bps hike, Shearing said if the MPC does not deliver this "could cause financial conditions to loosen and the pound to weaken, which is the last thing that policymakers at the Bank need right now".