This morning’s flash PMI reading for the UK reinforces our view that a September rate hike from the Bank of England will likely be the last of this cycle. Despite having been expected to show economic activity expanding modestly, the surprise contractionary reading of 47.9 for the composite PMI measure shows the lagged impact of policy tightening is increasingly weighing on the UK economy.
Granted, signs that wage pressures remain elevated mean that the Bank of England is not done quite yet, a slowdown in growth and employment suggests that a normalisation of inflationary pressures is now well and truly in the pipeline. This has now become apparent in the prices charged sub-index, which fell to its softest rate in February 2021 despite still strong input costs due to wage pressures as firms had to adjust their pricing strategies due to weaker demand. Put another way, the dreaded feedback between wages and prices is starting to abate. Given the revealed preference of BoE policymakers to wait for these signs to show up in hard data, today’s PMI report is unlikely to tip the balance at the September meeting.
But by November, the continued slowdown should be evident in the hard data and be convincing enough for the monetary policy committee to declare a pause in its tightening cycle.
The market response to the data saw Gilts rally strongly with yields falling across the curve, with both 2 year and 10 year down roughly 12bps. Whilst at the front end this reflected a trimming of Bank Rate expectations, which have largely priced out the idea of a jumbo rate hike in September, at the long end it suggests that a recent narrative of higher neutral rates is being called into question. For the pound this translated into a significant move lower, falling around six tenths against the dollar and five tenths against the euro in response to today’s news.
- Composite: 47.9 vs 50.4 expected
- Manufacturing: 42.5 vs 45.0 expected
- Services: : 48.7 vs 51.0 expected
Whilst an unexpected slowdown in the composite measure which printed a 31-month low, is likely to grab the headlines, there were several key points in the report that are likely to be more pertinent for policymakers. MPC speakers spent much of the Summer worrying publicly about the ability of firms to pass on higher wage costs to consumers, potentially fuelling an inflationary feedback dynamic. Therefore, it was notable that despite reporting persistently strong wage pressures, the survey also noted that average prices charged actually increased at the softest rate since February 2021, as firms readjusted their pricing in response to weaker demand and falling input cost inflation. This weaker demand outlook was also reflected across current activity, where levels ticked down across both the manufacturing and service sectors during August. Whilst in the latter case this was marginal, it was still the joint fastest fall recorded for 31 months.
The outlook here looks unlikely to improve either, with declining new orders across the UK private sector economy for the second month in a row and a steep reduction in backlog of work during August.
Another area of focus for policymakers is likely to be the labour market, where official data has been painting a mixed picture. Although leading indicators in today’s PMI report suggest the labour market data should eventually provide more consistent disinflationary signals, this normalisation is still yet to become visible. On employment, firms indicated that hiring slowed to a pace last seen in March, an outcome that is unsurprising given the official unemployment numbers have surprised to the upside two months in a row with the headline rate of 4.2% just fractionally below the Bank of England’s estimate of neutral. However, this is still yet to weigh on wage pressures. This stands in contrast to the recent Deloitte CFO survey that showed the ease of hiring increased in Q2 following difficulties earlier in the year. Nonetheless, with activity seemingly set to slow, the need to compete for talent and therefore bid up wages, should follow.
Given this outlook MPC members should be able to take confidence that the terminal policy rate is close, and instead start to worry that the balance of risks is beginning to shift towards the possibility of overtightening.
Indeed, some indications that the thinking of policymakers has shifted in this direction have already been seen. Granted the MPCs Swati Dhingra has consistently warned of this throughout the hiking cycle. But notably, key figures such as BoE Chief Economist Hugh Pill have appeared in our view to endorse the idea of rates staying tight for longer in recent weeks rather than necessarily chasing a higher peak this cycle. Markets too appeared to shift their outlook in this direction, as seen in the move in yields this morning.
Nick Rees, FX Market Analyst