The Bank of England delivered its sixth rise in interest rates of the year, with the half-a-per cent hike to 1.75% the largest since 1995, but this was mostly expected and has made barely a dent in the uncertainty for both households and financial markets.
The bank's monetary policy committee (MPC) now expects consumer price inflation to peak at 13% at the end of this year and still be running above 9% in a year’s time, with the economy expected to go into an official recession in the fourth quarter of this year and remain there for the whole of 2023.
Some economists believe the Bank is being too negative and will not hike rates much higher than 2%, but others think there is a chance that they could peak at 3%.
The grim outlook forecast by the MPC offers a rationale for the significant rise in the base rate, said Martin Beck, chief economic advisor to the EY ITEM Club, but he felt there were “several reasons” why the Bank’s central forecast may be on the negative side.
While the MPC judges that underlying inflationary pressures have increased, Beck said other data on pay and pay settlements “presented a less concerning picture”, running a bit above pre-COVID-19 levels, but showing few signs of an emerging wage-price spiral.
“High inflation may not prove as persistent as the Bank expects,” he said, also noting that the MPC forecasts are conditioned on market expectations of interest rates, which predict the base rate reaching 3% late next year,
This “seems implausibly high”, Beck said, if the UK economy contracts anywhere near as significantly as the the Bank expects.
Indeed, the MPC forecast shows inflation falling to around 1% in 2024, with a significant amount of spare job capacity opening up and the unemployment rate rising from the current 3.7% to over 6%.
Rate-setters “may well increase rates more cautiously than markets expect given the dominant force driving prices higher – more expensive gas – is outside the control of monetary policy, and the ultimately demand-reducing, and hence disinflationary, consequences of falling real household incomes,” Beck said, adding that with the predicted rise in household energy bills later this year, it “seems almost inevitable that the government will announce another significant package of fiscal support in the autumn”, which could significantly ease the impact to household spending.
More hikes ahead - but how many is the key
Paul Dales, chief UK economist at Capital Economics, is one of those predicting “the battle is far from over” and that rates may peak at 3%.
“In short, the Bank is forecasting stagflation and saying that the medicine is higher interest rates."
He pointed to the hawkishness of the MPC messaging, with a move to an 8-1 vote from the 6-3 split last time, showing “strong support for stepping up the pace of rate hikes” at the previous four meetings.
“Second, by saying once again that it will 'act forcefully' in response to 'indications of more persistent inflationary pressure', the MPC signalled its willingness to raise rates by 50bps again should the inflation data remain strong,” Dales said.
He noted there were a few caveats from the Bank to its forward guidance, including the new line that “policy is not on a pre-set path” and that the MPC will decide the “appropriate level of Bank Rate at each meeting”.
Another reading of this cautious language, said Samuel Tombs at Pantheon Macroeconomics, is that is suggests the committee “is uncomfortable with markets' pricing for 50bp hikes at the next two meetings”.
Indeed, Tombs said the MPC’s new baseline forecasts, based on energy prices holding steady after following futures curves for the next six months, and interest rates following the path expected by markets, "imply that it is nearing the end of its rate hiking cycle".
'Vicious' effects for households
There are an estimated 2mln borrowers on a tracker or standard variable rate mortgage that will see their rate rise in line with the increase.
The next few months may well prove to be the calm before the storm, said Laith Khalaf, head of investment analysis at AJ Bell, both as the warmer weather means we’re not paying as much to heat our homes, along with the fact that many more homeowners are still on low fixed mortgage rates.
He said higher interest rates are “a pretty vicious cure for inflation because they pile even more pressure on households across the country who are already beginning to struggle financially”.
But he acknowledged they are the biggest weapon in the Bank of England’s armoury, “and if the Bank hadn’t followed through with a 0.5% interest rate rise in the face of inflation rising to an expected 13%, its credibility would have been shattered, leaving the Governor with egg on his face”.
All eyes will be on the government's fiscal policies under whichever new Prime Minister is foisted on the country by the Conservative party.