Bank of England: Forced into overtightening
Executive summary:
- The Bank of England opted for the hawkish option today, hiking its key policy rate by 50 basis point (bps) to 5%.
- In the wake of the decision, yields fell for UK government bonds with 5 years or more until maturity.
- Market participants seem to believe that the Bank is overtightening and making a recession likely. We agree and think that UK gilts are now attractive. In contrast, further gains for the pound will be harder to come by.
Inflation in May had surprised on the high side yet again with a year-over-year rate of 8.7%, and core inflation re-accelerated to a concerning rate of 7.1%. In response to the inflation news, the Bank of England (BOE) raised the base rate today by 50 basis points (bps) to 5.0% with a vote of 7–2. Two members of the Monetary Policy Committee (Silvana Tenreyro and Swati Dhingra) preferred to maintain the bank rate at 4.5%.
The majority opted for the hawkish option of a larger hike when markets were on the fence between a 25- and a 50-bps increase. In our view, the bank is trying to counter the view that it is falling “behind the curve” on price pressures. With UK inflation being as sticky as super glue, markets are now pricing an interest rate peak at 6% by the end of the year. Even though the bank’s monetary policy summary pointed to falling future inflation pressures from declining cost indicators, the following paragraph suggests that the policymakers saw themselves cornered into action by the bank’s inflation mandate:
“The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. Monetary policy will ensure that CPI inflation returns to the 2% target sustainably in the medium term.”
Monetary policy works with long lags. Previous rate hikes are still working their way through the economy, for example through cooling the housing market. A standard 2-year fixed rate mortgage based on a 75% loan-to-value was at 1.2% in September 2021, and reached 6.29% on 21 June 20231, similar to the level after the gilts crisis in the autumn of 2022.
If interest rates stay as high as markets expect, mortgage borrowers could face a painful readjustment on their payments when their current deals expire. The Resolution Foundation estimates that annual repayments could be £15.8 billion a year higher by 2026 compared to December 2021, when the bank started increasing interest rates.2 Borrowers re-mortgaging in 2024 could see their repayments rise by £2,900 on average. In summary, the bank’s actions on interest rates are yet to be fully felt and will translate into a much weaker economy and lower inflation.
The bottom line
We think that UK gilts look attractive now as the Bank of England’s tightening campaign will sharply cool the economy and eventually bring down inflation. In currency markets, the pound sterling has risen strongly against the US dollar in recent weeks to 1.28. While it is still somewhat attractively valued3, it did not react positively to today’s hawkish move, indicating that further gains will be much harder to come by.
1 Source: https://www.uswitch.com/mortgages/uk-mortgage-rates-today/
2 Source: Resolution Foundation, 17 June 2023, https://www.resolutionfoundation.org/publications/the-mortgage-crunch/
3 The purchasing power parity exchange rate for GBP/USD is around 1.48. Source: Organisation for Economic Cooperation and Development.