The March MPC meeting saw eight of the nine members vote in favour of a 0.25% increase in base rates. While this came as no surprise, the Bank of England is now giving mixed signals to the market, indicating that future increases may not be imminent. The previous reference to a further tightening of monetary policy as “likely” is no more in the March minutes. So, what is the short to medium-term outlook for the UK and base rates?
Prospects for the UK economy
As we await GDP data for the first quarter of 2022, there is more focus on the medium to long-term prospects. The 0.2% decline in GDP in December was followed by a 0.8% increase in January. As a result, the latest forecasts suggest the first three months of 2022 are now expected to show growth of 0.75%. This is a significant change to the February report, which initially suggested a flat first quarter. Against this backdrop, it is near impossible to forecast the short to medium-term performance of the UK economy with absolute confidence.
While traditionally, the Bank of England has used base rates to control consumer “exuberance”, the spectre of high inflation seems to be working. There are signs that consumer confidence is turning downwards and that demand for goods and services is starting to weaken, but time will tell. This is one of the reasons why the Bank of England seems reluctant to commit to further short-term interest rate rises. If only energy prices were under control, we might be able to get a clearer picture of the short to medium-term prospects.
Unemployment in the UK
November’s Labour Force survey confirmed an expected fall in unemployment to 4.1% over the previous three months. The latest data shows that unemployment fell further to 3.9% to the end of February, which is encouraging. However, the Bank of England now believes that unemployment will soon turn upwards with a suggestion it will hit 5% by 2025.
As expected, the massive increase in energy prices is having an impact on the cost of goods and services on a global basis. If you also factor in supply and demand issues, prices are moving beyond the reach of many people. An expected softening of demand and signs that consumer confidence has turned downwards are not positive signs for the employment market. Companies are likely to look at their staffing numbers and make changes. In what can quickly become a self-fulfilling prophecy, an upturn in unemployment leads to less demand, more job cuts and the vicious circle starts.
Inflation in the UK
The CPI measure of inflation rose from 5.4% in December to 5.5% in January, and this is before the full impact of further energy price rises due to the Ukraine/Russia conflict. Inflation is expected to hit 6% for February/March, with further increases likely during 2022. The February report highlighted the challenges of energy prices, assuming they would be 20% higher at the October 2022 cap reset. If prices remain at current levels, they would be nearer 35% higher, which will have a short to medium-term impact on inflation. More challenges ahead!
If we look back to the February MPC minutes, the indication was that inflation would peak at 7.25% in April. However, due to the Ukraine/Russia conflict, UK inflation is expected to rise to around 8% in April. It could even hit double digits towards the end of 2022. Over the last few months, we have seen previous forecasts adjusted regularly. However, the MPC was slow to act on high inflation and seems unsure when and at what rate it will peak, which does not bode well. Markets look to the MPC for guidance and advice, and unfortunately, much of the data released is very quickly outdated.
While MPC supporters will point to the uncertainty surrounding energy prices, prices had already begun to spiral out of control before the Ukraine/Russia crisis. The Bank of England hoped inflation would reset itself without further monetary policy adjustments. Analysts will look back on the last 12 months as perhaps one of the most challenging and controversial times for the Bank of England and the MPC. If the MPC, with all of the confidential data available to it, cannot get a handle on inflation, where can we look for guidance?
UK interest rates
While the UK base rate has increased from 0.5% to 0.75%, the third consecutive monthly increase, it appears the MPC is reluctant to commit to any further short-term changes. As we touched on above, removing the term “likely” when discussing potential short-term increases has caused some confusion. However, the market-implied route for further interest rate rises suggests they could hit 2% by the end of 2022.
The Bank of England seems to be playing down what was perceived as an aggressive tightening of monetary policy in the February report. Indeed, the four members who called for a 50 base point rise at the February meeting voted for the 0.25% increase in March. However, it seems as though the hawks are now turning into doves in the short term. Why?
The Bank of England and MPC are caught between a rock and a hard place. If they move to an ultra-aggressive monetary policy in the short to medium-term, this could exacerbate the ongoing decline in consumer confidence. But, on the flip side, if they take their foot off the gas and stall on further interest rate rises in the short-term, this could further feed the inflation monster. Moreover, while much of the focus is on energy costs, there are still worldwide supply issues for many goods, causing an imbalance in the supply-demand ratio.
Will the ongoing tightening of household incomes weaken short to medium-term inflation? The MPC believes that inflation will fall to just above 2% within 24 months but could take three years to fall below the 2% target rate.
What happens next?
It is fair to say that the last 12 months have been challenging for the Bank of England and the MPC. Navigating through the Covid pandemic was challenging. Factoring in supply and demand issues is proving impossible, and now we have a considerable increase in energy prices. After seemingly taking a more aggressive approach to tightening monetary policy, the latest indications are that the MPC is taking its foot off the gas.
Interestingly, one of the MPC members voted not to increase base rates. He believes that a natural dampening of consumer confidence due to high energy prices and stubbornly high inflation would lead to reduced demand. We live in very challenging times, with near historically low-interest rates and a relatively strong economy, but energy prices and inflation have gone through the roof. Sitting back doing nothing is not an option, but are you brave enough to call the next move by the MPC?