Today the Bank of England’s Monetary Policy Committee voted by 8-1 to raise interest rates from 0.1% to 0.25%. This move was small but significant, it was also welcome and necessary.
A hike was always possible in the wake of the latest jobs and inflation data this week and also given that last month it had been a close call when the Bank chose to leave rates unchanged. Nonetheless, the markets were not expecting a hike this week, in part because of the new Omicron variant.
Omicron will hit the economy over the coming months and not just in December, as government measures may remain in place over the winter and as people’s behaviour will be more cautious, with some sectors like hospitality hit hard and the wider uncertainty denting consumer and business confidence. But with vaccination rates high and booster rates increasing, the economy could rebound sooner.
The policy target for UK consumer price inflation (CPI) is 2%. This week, the annual rate of CPI hit 5.1% in November. Meanwhile, the annual rate of retail price inflation (RPI), whose rate at other times during the year influences a range of things including fare increases and student loans, reached 7.1%.
Inflation is set to head higher over the next few months. Ahead of this latest variant I thought it would peak around 7% to 7.25% next April, but depending on how firms respond to this variant that spike could now be 6.1%. Rather than try to be precise, the key point is that inflation will remain elevated. The Bank of England, meanwhile, previously talked of inflation being above 5% by next spring, now they see it above 6%.
The annual rate may ease off in May and June slightly, but it will not be until the second half of next year that annual inflation falls significantly – but even that pace of decline will depend on many factors. One risk is that oil prices spike higher again later next year. The key, however, is the inflation feedthrough as firms may be passing on higher costs and raising prices to either maintain or raise their profit margins.
Wages may also trend higher as the labour market has recovered, although unfortunately some areas like hospitality and the creative sector may be hit hard by this variant. By next autumn, annual inflation may be back to just below 5% and trending lower.
The Bank has not read the inflation dynamics well – misreading the persistence of this rise in inflation and the extent to which inflation has risen. Part of the role of a central bank is to ensure it does not accommodate any pass through of inflation into the wider economy – and they have been slow to guard against this.
This small rate hike can in no way be interpreted as the Bank being ahead of the curve, especially alongside the unnecessary scale of Quantitative Easing (QE). Also, in contrast to the Fed, communication with the market has been poor. The latter is important in order to minimise market volatility as rates rise further and as they are forced to reverse their asset purchases through Quantitative Tightening (QT).
I have previously argued in favour of small hikes (today’s was only 0.15%) as opposed to no action. But even after today’s move UK rates are still at low levels – given growth and inflation. They were 0.75% before the pandemic, itself a low rate. Further gradual tightening is likely but not imminent given the uncertainty from the new Omicron variant.
Also, it is not just monetary stability (in the form of higher inflation) but, as I have noted previously, financial stability that has been threatened by the Bank’s easy money stance. QE has finished this December, reaching £895 billion. As noted previously, I thought this should have halted some time ago.
The Bank’s actions follow hawkish comments from the US Federal Reserve (the Fed) yesterday when it provided further clarity on its exit strategy.
Financial markets are taking their lead from the Fed and there are three components to note there: the aim to tighten over the next year via higher interest rates; tapering via phasing out and ending its asset purchases; and guidance to the markets via effective communication. In particular, on the latter, the Fed has treated the financial markets with respect, been clear in its communication and thus kept the markets onside, reacting calmly to the latest announcements from Fed Chair, Jay Powell.
Despite the surge in US inflation since early summer, which caught the Fed and markets by surprise, the Fed’s guidance and communication has seen its credibility enhanced. Now the market believes it is on top of the inflation scare, and hence this week’s news that they would tighten was received well by the markets.
The Fed now believes inflation will spike at a higher rate than previously thought but will still trend lower. Their preferred measure is the PCE deflator. In September their forecast was that it would average 3.7% this year. Now they say 4.3%, but even so they expect it to decelerate to 2.7% next year and 2.3% in 2023.
Concerns about the jobs market were previously preventing the Fed from taking more aggressive tightening action. Now, and even though employment is still below its pre-pandemic level, in the wake of recent data, the Fed now sees a significant improvement in the unemployment rate. As recently as September the Fed forecast the unemployment rate to be 4.8% this year and 3.8% next. Now they forecast 4.3% and 3.5%.
Thus their more hawkish but still managed tone. Importantly though, their current policy is still accommodative. As Powell said, the economy no longer needs, “increasing amounts of” policy stimulus. Therefore, their tone is more hawkish but they are still stimulating – it is a gradual and predictable exit strategy consisting of:
- tapering. Before November the Fed was buying $120 billion of bonds per month. In December it will be $90 billion, $60 billion in January and ended by April.
- tightening via higher rates. Currently rates are between 0% and 0.25%, so 0.1%. They project three quarter point hikes next year, three in 2023 and two in 2024. Even though six of the 18 members think they will need less than three hikes next year the message is uniform: expect higher policy rates.
The Bank’s hike and the Fed’s actions are indicative of a tightening cycle in global monetary policy. A third of the central banks in the world’s largest 100 economies have already tightened this year. But it is domestic factors that are driving this.
In the wake of the 2008 global financial crisis there was a coordinated global policy stimulus, led by monetary policy but supported by fiscal policy. However, since then, exit strategies have varied as countries tightened at different rates and speeds.
Likewise now, the pandemic has triggered a huge monetary and fiscal policy stimulus. Strategies on fiscal policy vary across the globe – naturally heavily influenced by domestic politics. The US is still relaxing fiscal policy through increased government spending. In contrast, the UK has already announced tax hikes. But the main focus of financial markets is on monetary policy because of rising inflation.
There is clear divergence in monetary policy across the globe. China eased policy last week, in part because it has kept monetary policy prudent but now needs to act as its economy slows. The ECB, meanwhile, perhaps chastened by tightening too much after the 2008 crisis, is keen to keep monetary policy accommodative and unchanged. Likewise, the Bank of Japan. Then yesterday the hawkish message from the US Fed and today the small rate hike from the Bank of England.
Please note, the value of your investments can go down as well as up.