Monetary Policy Report: tending to the patient?
The Bank of England (BoE) recently released its Monetary Policy Report alongside the minutes from its August Monetary Policy Committee (MPC) meeting. While there were no major surprises, the report does signify the direction of the UK economy, and indicate what the market should look out for in the near-to-medium term. Overall, the messaging appeared to be positive on the UK’s recovery, but any resulting policy changes would still need to be taken with a patient and cautious approach.
Base rate and asset purchases
The Bank Rate has been kept at 0.1% and the target stock of gilt purchases in the quantitative easing (QE) programme remains at £875 billion.
The MPC also reiterated a preference to use the Bank Rate as its active instrument when adjusting its policy stance. The market prices in modest rate hikes to 0.25% by the end of 2022 and 0.5% by the end of 2023; based on this, the Bank of England forecasts that CPI inflation will end the forecast period at just below its 2% target.
While the decision to maintain the Bank Rate at 0.1% was unanimous, Michael Saunders believed the economic outlook warranted a reduction in the scale of asset purchases. Saunders believed that on the current policy setting, inflation is likely to remain above the 2% target for more than two years ahead, given the prospect of larger and more persistent demand from the UK, together with supply-side cost pressures. The remaining committee members, however, did not vote in favour of this view.
One development from the meeting is the level at which the stock of purchased assets is scaled back. Subject to economic circumstances, the MPC intends to cease to reinvest in government bonds when the Bank Rate has risen to 0.5%; previously, guidance suggested the required level was around 1.5%. The new level of 0.5% incorporates the view that negative rates are now formally part of the BoE toolkit; although focus has shifted away from negative rates as the recovery has gathered steam, it’s nevertheless worth remembering when considering the range of potential outcomes in future downturns.
The MPC would also “consider” the active sale of gilts once the Bank Rate reaches 1%, although based on current market prices – which imply a peak in rates of 0.75% – this threshold would not be met soon.
Inflation remains high, and the BoE expects a 4% peak at the turn of the year. This is a revision from its previous peak estimate of 2.5%, as consumer demand has risen since restrictions have been lifted. However, several businesses are struggling to meet demand amid supply issues in sourcing production materials, particularly around shipping and semiconductors.
The BoE maintains the view that recent increases in inflation should still be considered transitory and does not expect demand to continue to rise as fast. Policymakers will nevertheless continue to monitor the risk that domestic and global demand and cost pressures could affect medium-term inflation expectations. Inflation levels are expected to normalise during the second half of 2023.
The economic backdrop shows signs of resilience and recovery as vaccination take-up in the UK has helped boost spending, jobs and incomes. Since the previous meeting, despite an increase in COVID-19 cases, hospitalisations and deaths have risen to a lesser degree than in previous waves. The MPC’s economic forecasts remain reasonably bullish, with GDP growth estimates of 5.0% (up from 4.25%) and 2.9% (down from 3%) forecast in the second and third quarters, respectively.
In the labour market, the MPC expects the unemployment rate to fall over 2021-2022, which is different from what was originally envisaged once the furlough support scheme came to a halt. Despite a positive outlook overall for the labour market, the number of individuals in employment is lower than pre-pandemic levels.
Key takeaways for investors
To conclude, should the economy progress as the BoE forecasts, the Bank may consider some modest tightening over the next two years. As QE draws to an end later this year, this may mark the peak in the size of the BoE’s balance sheet, as any future easing will lean more heavily on negative rates, while balance-sheet reduction through a cessation of reinvestments or active gilt sales will form a greater part of future tightening cycles. Should interest rates rise to 0.5%, the gilt market will have to stand on its own two feet, without the support of the BoE for the first time since 2011.