Bank of England: A dovish last hike

Executive summary:

  • Full effect of interest rate hikes from late 2021 are still to be fully felt.
  • The housing market is softening but has further to go.
  • Following recent bank failures, central banks are going to be mindful of further monetary tightening.

The Bank of England raised its key interest rate by 25 basis points (bp) to 4.25% today. We think this could be the central bank’s last hike in this cycle. As the Bank of England and other major central bank approach their interest rate peaks, the time of bond market pain should be mostly behind us.

Members of the Bank of England’s monetary policy committee voted 7 to 2 in favour of the hike. Silvana Tenreyro and Swati Dhingra preferred to leave the rate unchanged. The split in the vote illustrates the conflicting forces affecting the UK’s growth and inflation outlook.

At 10.4% in February, annual consumer price inflation is still way too high. However, some more forward-looking wage and inflation indicators suggest that price pressures are receding. Regular private sector pay growth has slowed down to a rate of 6% compared to this time last year. Business surveys indicate that decision-makers at companies expect to raise their prices at a slower pace, also thanks to falling energy prices.

As we wrote in our commentary on the Budget last week, the UK economic outlook has brightened somewhat compared to late last year. Next month, around 20 million adults will benefit from a 10% uplift in their state pension, universal credit or living wage, easing the cost-of-living challenge. The extension of the energy bill support announced in last week’s budget and the decline in wholesale energy prices will also lessen the burden on households. 

On the flipside, much of the dampening impact of the interest rate hikes since late 2021 has not yet been felt. Higher bank rates are still working their way into mortgage payments as mortgage deals come up for renewal. A standard 2-year fixed rate mortgage was at 1.2% in September 2021, reached a peak of 6% after the gilts crisis in the autumn of 2022 and is now at 4.8%1. Housing has softened, with approvals of new mortgages dropping sharply, but is likely to weaken further. While the economic outlook is not as bleak as a few months ago, tepid growth and rising unemployment are still ahead.

The bank failures in the US and Switzerland in recent weeks will likely influence monetary policy. Central banks are going to be more mindful of the impact their tightening has on financial stability and the ability of banks to extend credit.

The bottom line

What a difference six months make. After the poorly received mini-budget in September 2022, markets expected the bank rate to reach a peak of around 5.5%. Today we may have seen the last rate hike in this cycle taking the bank rate to 4.25%. Mortgage borrowers will breathe a sigh of relief, as will bond investors. We believe that the pain for UK gilt investors is mostly behind us. In foreign exchange, the pound sterling is still cheap2 and could continue to gradually rise against the dollar, especially if the Fed is also approaching the end of its rate hike cycle.

[1]Source: Refinitiv Datastream as of 28 February 2023.

[2] The purchasing power parity exchange rate for GBP/USD is around 1.48. Source: Organisation for Economic Cooperation and Development.