Bank of England delivers record rate hike, but outlook darkens
The BOE did what 80% of the market had expected them to do, and they raised interest rates by 50bp, the largest rate hike in 27 years. This was fully expected by the market; however, the Bank’s Monetary Policy Report delivered a blow to those who thought the UK was on its way out of the cost-of-living crisis. Instead, it expects a recession lasting more than a year, and inflation to reach a peak of 13% at the end of this year. Now that the Bank of England is out of the way, all eyes will turn to Friday’s US labour market report, scheduled for released at 1330 BST, where the market will be looking for signs of economic weakness to see if the Fed will perform the famous pivot that drove stocks higher in July.
The beleaguered householder and why the UK is in a worse position than the rest of Europe
The BOE meeting highlighted what we have been saying for some time: this is not a normal economic cycle. The most noteworthy economic revisions from the BOE included GDP, with the BNOE expecting a long, drawn-out recession for the UK. The Bank now expects the recession to last from Q4 2022 – Q4 2023. Forecasting a five-quarter recession is far from normal, most recessions are not as long-lasting, however, what is more shocking is that householders are going to be shouldering the biggest load. The bank is also forecasting inflation that will peak at 13% by year-end, more shocking is that the Bank expects energy costs to swallow up 9% of household spending next year. This is already changing peoples’ spending habits. The BOE noted that the latest ONS Opinions and Lifestyle Survey found that 60% of respondents said that they were spending less on non-essentials. Due to the UK’s reliance on the consumption, the hobbled consumer is the main reason why the UK is expected to have a longer-lasting recession than its EU and US counterparts.
Can the UK take a more European approach to inflation?
In the EU, countries such as France and Germany are shielding their householders, particularly the poorest, from energy price rises. There is some variance in Euro-area energy prices, for example in France energy prices have risen by 30%, compared with 80% for the Netherlands. The variance with the UK is explained by government policy, most euro-area countries have adjusted energy taxes in some way, and some have imposed caps on retail and wholesale prices. In contrast, the UK energy price cap will now be reviewed 4 times a year, so that the UK consumer feels the effects of rising wholesale prices faster. This may sound bonkers, because it is bonkers. The energy price cap in the UK is not a cap if it continues to move higher. It was put in place by the Labour government to protect wholesale energy suppliers. It was only designed to be a temporary measure, the fact that it is still in place is the reason why consumers are in such a desperate position 25 years later.
The BOE passes the baton to the next leader of the Tory party
The BOE, by itself, can do little to protect consumers from the erroneous effects of global inflation like surging energy prices. Instead, it will be left up to the government and the next Prime Minister to act. The news that 9% of household income will be swallowed up by energy costs in 2023 should lead Rishi Sunak and Liz Truss to dramatically alter their fiscal priorities. They should prioritise financial support to households, and a change to the energy market structure so that we get out of this mess in better shape than we are currently in. However, right now we have two candidates who are tussling over tax cuts, which the UK can ill-afford. Thus, the battle to be the next resident of 10 Downing Street is not filling me with hope for the UK economy.
Other notable points in the BOE Monetary policy report:
· The BOE now predicts that UK Interest rates will peak at 3% in Q2 23, with a downward sloping curve further out. The average market path is 30bp higher than it was in May.
· The overall market survey of UK interest rates is lower than the BOE’s projections, with rates expected to peak at 2.5%. This is 75bp higher than in May. However, the divergence can be explained by the high level of economic uncertainty.
· Availability of bank credit to large firms remains steady, however, there is a tightening of financial conditions for the construction sector, which tends to be a lead economic indicator.
· The BOE thinks that households can absorb some of the rise in the cost of living by 1, spending excess savings, 2, choosing to work more or 3, seeking a pay rise.
· The MPC baseline projection for the UK savings rate is expected to decline from 6.6% in Q1 to 5.1% in Q3. Thus, there is not much room for the savings rate to save the day for most households. Added to this, the savings rate is biased towards richer households, with a large proportion of poorer households having no excess savings to spend during this period.
· Long term inflation expectations have fallen from recent highs, but they remain elevated at close to 4%, based on 2-year inflation expectations 5 years ahead.
· Firms’ inflation uncertainty is also elevated, when this happens it is associated with larger forecasting errors by firms when predicting their own growth. This could be bad news for stocks.
· The labour market is likely to remain tight, the BOE survey data has found little evidence of companies planning to reduce headcount in the next 12 months.
· Pay settlements are expected to increase by 6% over the next 12 months.
· The UK labour market is proving to be a big headache for the BOE for a few reasons, including the fact that it is tighter now than it was pre-pandemic.
· The ONS underemployment rate is at a 15-year low, and the Marginal Attachment Ratio, which measures the proportion of people who report that they would like a job, but they are not actively looking for one, is 2% below pre-Covid levels.
· The BOE will also start shrinking its balance sheet in September. It will aim to sell £80bn of bonds per year, which is £12bn per quarter + maturing bonds rolling off the BOE’s balance sheet.
· The BOE will put in place a mechanism to halt bond sales if they start to disrupt the functioning of financial markets.
Overall, the big question for the BOE is, how will the labour market tightness respond to slowing demand? Due to its excessive tightness, it could take longer for the labour market to loosen materially in response to falling demand. Thus, the BOE’s rate-hiking cycle could take some time to take effect. At this stage this means two things: the BOE may have to hike rates for longer, and the neutral rate could be above 3%, and inflation at 13% could be here to stay until the BOE can engineer a loosening of the labour market, i.e., more unemployment.
The technical view: GBP/USD
The pound had a rollercoaster ride on the back of the BOE report, with GBP/USD initially sinking below $1.21, however, it has since climbed back to $1.2135 at the time of writing. This is possibly a reaction to the BOE’s assertion that policy is not on a pre-set path, essentially following the Fed and ditching forward guidance. Since the BOE is committed to bringing inflation back down to the 2% target rate, there could be further rate hikes to come, which could stem the decline in the pound in the medium term. However, in the immediate term, the pound looks like it is in a neutral gear as the market weighs up the latest news from the BOE. If short-term support holds at $1.2060, then it supports a short term move back to resistance at $1.2290. If this level is broken, then it opens the way back to a more meaningful rally towards $1.24.