News & Analysis

The Bank of England today voted 5-4 in favour of holding rates at 5.25% as opposed to hiking a further 25 basis points, with Governor Bailey playing kingmaker in the decision. The “finely balanced” vote split represented just how much uncertainty had built up around today’s decision following yesterday’s release of August’s inflation report, which showed services inflation unexpectedly collapsing to 6.8% YoY, below the BoE’s August forecast.

It seemed as if this tipped the balance within the MPC to hold rates as, coupled with signs that labour demand is now slowing, this meant that two of the three measures of inflation persistence monitored by the BoE are now improving. Bemusingly, however, data on the third metric, wage pressures, were now being downplayed. The Bank’s monetary policy statement highlighted that “the recent path of the Average Weekly Earnings is, however, difficult to reconcile with other measures of pay growth”, which on the whole have remained stable.

While these were the official lines taken within the BoE’s rate statement, the meeting minutes suggest that not all policymakers are viewing the recent rounds of economic data in this light.

Those voting for a further hike in rates pointed towards volatile components such as airfares generating the recent decline in services inflation, while the normalisation in labour market conditions had been slow. Based upon the fine vote split and the inconsistencies within the aggregate data, we think today’s decision should be viewed in a similar fashion to the Fed’s June decision, where policymakers hawkishly held rates to observe more data.

Therefore, despite BoE communications tilting more dovish in recent months, we don’t think the data is compelling enough to officially call the end of the hiking cycle. Although we do note that November’s meeting, which is accompanied by a fresh MPR, is likely the last feasible time for a hike this cycle.

While the BoE’s decision to hold was a surprise to markets, the Bank’s decision on its quantitative tightening programme was not. The MPC today unanimously agreed to increase the pace in which its balance sheet is reduced, with the stock of Gilts set to fall by £100bn between October this year and September 2024. This was in line with market expectations and would represent a sustained pace of active gilt sales alongside a slight uptick in the amount of maturities.

Sterling and UK rates have moved in lockstep since the start of the year

For sterling, much has been made about the recent decline in UK terminal rate expectations and the impact that has had on dragging the currency lower. While the pound has continued to slump again today as markets react to the BoE’s decision to hold in an environment where the Fed has signalled a “much higher for far longer” path, we think this may be opening up a decent buying opportunity in the currency. While we are cognisant this view runs against the recent trend in GBPUSD, the increasingly bearish GBP view taken by option markets, and the BoE’s latest decision to pause which potentially suggests a higher tolerance to inflation or concerns over a more pronounced slowdown, we think there remains a path higher for sterling on the basis of another rate hike in November and a string of constructive growth data. Our conviction in this call is notably greatest against the euro, where we believe the ECB faces a difficult policy environment.

Tomorrow’s release of August’s retail sales data and September’s preliminary PMIs will be the first measures to this effect. In the event that they show improving inflation and growth dynamics heading in the back end of the third quarter, we think sentiment around the pound will begin to recover.

Services inflation significantly undershot BoE forecasts in August, tipping the balance for the BoE

For the second time this year, the BoE appears to have been bounced into a decision by a CPI release that landed just as the MPC meeting began. Last time in June, a broadly hot release saw the BoE surprise markets with a 50bp increase. This time, in contrast, CPI services inflation dipped below BoE forecasts, which in turn led the Bank to hold rates in a contradiction of broad pre-announcement guidance. While on the surface, it shouldn’t be surprising that better-than-expected inflation developments resulted in a more dovish response by policymakers, however, the overall services measure of inflation was heavily skewed by seasonal distortions this time around. With the BoE even admitting this and that “once removing travel-related components such as these, services inflation had been more stable at continued high rates”, it is safe to say that the Bank’s reaction function is becoming increasingly opaque.

The Beveridge curve shows the UK labour market continues to cool, but also that the BoE’s job is not done yet

Granted, the labour market is undoubtedly cooling, as signalled in the July data release. Unemployment rose to 4.3%, above the BoE’s equilibrium estimate, with employment growth also showing signs of growing weakness. The Beveridge curve too indicates that the labour market is beginning to normalise, though crucially has some way to go if conditions are to return to their pre-Covid norms. That being said, arguably the key data series that the BoE had indicated as underpinning their decisions, is yet to show signs of sustainable cooling. Regular private sector wages grew by 8.1% 3m YoY in July, down just 0.1pp from the June figure of 8.2%. Not only this, but Bank staff forecasts has projected pay growth on this measure to fall from 7.6% in June to 6.9% in September, a decline that has no prospect of being achieved given the current evolution of data. Admittedly, alternative measures of wage growth had shown greater signs of a slowdown.

But even so, the Bank’s decision is perplexing given the emphasis they had placed on a downturn in this measure as a precondition for pausing their tightening cycle, only to discredit it in determining today’s decision.

Even though inter-meeting commentary by Chief Economist Huw Pill and Governor Andrew Bailey suggests that today’s decision to pause rates may be the start of an elongated pause in the hiking cycle, we are not confident that this is the case. Not only does the fine vote split and the continued view that risks to the BoE’s inflation forecasts remain to the upside suggest that further rate hikes may be forthcoming, but so does the inconsistent readthrough across the aggregate data.

As such, we think today’s decision should be viewed in the same light as the Fed’s June decision, that is a “hawkish pause”.

 

 

Authors: 

Simon Harvey, Head of FX Analysis

Nick Rees, FX Market Analyst

 

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