Bank of England decision: analysis from our experts
Pushing back against market pricing
The Bank of England (BoE) voted 7-2 to keep interest rates unchanged today, but teased that a rate hike was likely necessary “over coming months”.
While we believe the UK labour market has survived the wind down of furlough, the BoE Governor hinted that the committee would have two official post-furlough labour market data releases by its next meeting on 6 December, to confirm how tight the labour market is.
While LGIM’s economists believe it’s a good idea to act pre-emptively ahead of the 2022 pay rounds, the BoE was concerned that if it raised rates prematurely, it would be hard to re-stimulate the economy given their lower bound.
By contrast, if it acted too late, it could raise rates “as much as needed”. If the BoE is concerned about the lower bound, the European Central Bank must be scared given its lower ‘inflation memory’ starting point.
More important than the timing of the first hike, the BoE pushed back against the scale of rate hikes priced in by money markets if energy prices were to fall back in line with their futures curves.
So while it seems to be waiting for confirmation of a near-term hike, the Bank didn’t agree with the full extent of hikes priced into the market.
Why take the risk?
At some point, the BoE may get scared that inflation is at risk of remaining too high for too long. If people start to expect high future rates of inflation, because it is in many ways a self-fulfilling prophecy (wage bargaining is usually assumed to start with ‘at least inflation’), higher expected inflation will make it harder for the Bank to bring inflation back down.
In not tightening policy today, we believe the Bank is revealing that it’s not yet confident that the risks associated with ‘too high for too long’ are greater than the risk that it raises interest rates too fast and causes an unnecessary slowdown in growth and employment.
Which of these two risks the Bank views as dominant – and which scenario causes its policymakers maximum regret – seems very finely balanced. There’s no other way to explain their otherwise surprising communications over the past month.
The gilt edge
Today’s decision saw a sharp move in gilt markets, with a rate hike now priced in for December and the peak in rates moving lower to around 1%. Shorter-dated yields have fallen to a greater extent than longer-dated yields, which would suggest that market participants are less fearful of an aggressive move in interest rates that proves to be a policy error.
Inflation markets responded to today’s move by pricing in a higher level of inflation over the coming years as, even though the BoE believes that inflationary pressures are transitory, there remains concern over the persistence of inflationary pressures going forward.
The decision to continue with quantitative easing is an unwelcome one, from my perspective. Whilst the Bank had communicated that asset purchases were likely to last into December, the gilt market has suffered from relatively high levels of illiquidity, with short-dated government bonds and treasury bills being particularly badly affected, as a result of a sharp reduction in supply following last week’s Budget.
The shortest-dated gilt now trades at a yield of negative 9 basis points, despite the Bank’s intention to tighten rates. The ongoing purchases of government bonds by the BoE are likely to make this problem worse as the year end approaches.