Buses pass in the City of London financial district outside the Royal Exchange near the Bank of England on 2nd July 2021 in London, United Kingdom.
Mike Kemp | In Pictures | Getty Images
With U.K. inflation running at a 40-year high of 10.1% in September, the Bank is seen hiking its main lending rate for the eighth consecutive time, but weaker growth momentum and a major shift in fiscal policy is expected to ease calls for more aggressive monetary tightening.New Prime Minister Rishi Sunak has scrapped the controversial tax cuts at the heart of predecessor Liz Truss’ fiscal policy agenda, meaning fiscal and monetary policy are no longer pulling in opposite directions.
The government U-turns, which eased market tensions, mean the Bank’s Monetary Policy Committee (MPC) will not have to counter the additional inflationary impact of government policy, as it weighs the possibility of weaker growth ahead.
Goldman Sachs economists on Monday lowered their 2023 U.K. growth projections from an annual rate of -1% to -1.4%, citing what is likely to be a less generous household and business energy cost assistance scheme under Sunak.
“We therefore see less pressure for the BoE to act aggressively at next week’s meeting, but we still believe that a step-up in the pace to 75 basis points is likely given that (1) fiscal policy is on net more expansionary than assumed at the August MPR meeting; (2) news on the labour market and underlying inflation pressures has been firm; and (3) MPC commentary points to a robust policy response at the November meeting,” Goldman’s economists said.
The Wall Street giant expects a split vote in favor of the 75-basis-point hike on Thursday with some chance of another half-point uplift in December.
“We expect the MPC to explain the step-up in the hiking pace with ongoing inflationary pressures and the additional support to demand from the announced fiscal measures,” Chief U.K. Economist Stefan Ball and Chief European Economist Jari Stehn suggested.
“However, we do not expect significant changes to the forward guidance and look for the MPC to retain its meeting-by-meeting approach.”
Deutsche Bank also expects a split vote on Thursday in favor of a 75-basis-point hike, taking the key interest rate to 3%.
In a note Friday, the German lender said it expects the MPC to relay three key messages to the market.
The first is that the economic outlook has deteriorated further and the U.K. economy now faces a “deeper and more prolonged recession” than previously thought, while price pressures are likely to pick up in the short-term before cratering by the end of 2025.
“Second, policy is not a pre-set path. Risk management considerations, however, warrant further tightening and front loading of rate hikes, given increased volatility in inflation (with the end of the Energy Price Guarantee slated for March 2023), a broadening out of price pressures, and a ratcheting up of wage and price growth in the year ahead,” said Deutsche Bank’s Chief U.K. Economist Sanjay Raja.
“As such, policy will need to go a little further than anticipated, moving further into restrictive territory, particularly with inflation expectations slipping, and second round effects firming.”
Perils of over-tightening
Raja also noted that there are limits to monetary policy tightening, suggesting that an eventual Bank Rate of 5% — as expected by markets — would result in balance sheet stress for households and businesses already struggling.
“We expect the MPC, including the Governor at the press conference, to stress that while the Bank remains fully committed to fighting off excess inflation, it will attempt to avoid an over correction in rates that would set the economy back further from its pre-pandemic levels,” Raja added.
Deutsche Bank now expects the Bank Rate to reach 4.5% by May next year, down from its previous projection of 4.75%, on account of retreating fiscal stimulus and a push toward fiscal consolidation.
Bank of England Deputy Governor for Monetary Policy Ben Broadbent said in a recent speech that GDP would take a “pretty material” hit from such aggressive policy tightening. The Bank’s August growth forecasts, which already pointed to a five-quarter recession, were based on a much lower Bank Rate of around 3%.
“The new set of forecasts due, which crucially are based on market interest rate expectations, are likely to be dismal — showing both a deep recession and inflation falling below target in the medium-term,” noted ING Developed Markets Economist James Smith.
“That should be read as a not-so-subtle hint that market pricing is inconsistent with achieving its inflation goal.”
Dovish Bank of England leaves pound vulnerable
Having sunk to a record low against the dollar in the aftermath of Liz Truss’ disastrous fiscal policy announcements in late September, the pound gained some respite from Sunak’s appointment and his retention of the more moderate Finance Minister Jeremy Hunt.
Should a 75 basis point hike on Thursday be accompanied by dovish rhetoric, as economists expect, sterling could be left vulnerable given the market’s apparent overpricing of the terminal rate, according to BNP Paribas.
“Given the squeeze in GBP shorts over the past week, a dovish BoE hike is unlikely to bode well for the currency. As such, we stay short GBP into the meeting,” the French lender’s strategists said in a note Monday.