Stubborn inflation prompts Bank of England to diverge from the Fed

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As far as the Bank of England is concerned, it is too soon for a pivot in the battle against high inflation.

That was the strong message from Threadneedle Street on Thursday, just hours after the US Federal Reserve lit a fire under global markets by heralding rate cuts in the new year.

While Jay Powell, the Fed chair, seized upon favourable trends in US inflation and labour markets as he executed a U-turn on the interest rate outlook, BoE governor Andrew Bailey and his colleagues went to lengths to downplay any tentative signs of good news in the UK economy. 

Voting six to three to hold rates at 5.25 per cent, the BoE’s Monetary Policy Committee warned it is confronting a more stubborn problem with inflation than its counterparts across the Atlantic — or indeed in the euro area, where the European Central Bank also held rates today.

“They are minded to keep policy restrictive well into 2024, and that is a sharp contrast with the Fed,” said Jens Larsen, a director at Eurasia Group. “The Fed’s [decision] was a surprise and a pivot. The BoE has not pivoted at all.” 

The hawkish message in London was partly because the BoE remains anxious to avoid domestic criticism that it might underestimate the inflation outlook. Last month a committee of the House of Lords accused the bank — and its peers — of “complacency” about inflation after the Covid-19 pandemic.

But as the minutes to the latest bank decision made clear, policymakers genuinely believe the UK is in a deeper hole with regard to inflation than its peers. 

Wage growth is higher in the UK than in the US and euro area, as is services inflation and the “core” measure of prices that strips out food and fuel, the minutes noted.

Like the eurozone, the UK was hit far harder by the energy price upsurge than the US. Most evidence suggests the British labour market is still tighter than before the pandemic, boosting wage growth.

There are 957,000 vacancies in the economy, about 100,000 more than on the eve of the pandemic. A Bank of England survey of chief operating officers in November found that 50 per cent of businesses reported they were finding it harder than normal to recruit employees.

The latest UK figures showed that average wages grew by an annual rate of 7.3 per cent in the three months to October. The number was sharply down from a summer peak of 8.5 per cent but still higher than in the US and the eurozone. US average earnings grew at an annual rate of 4 per cent in November, while in the eurozone negotiated wages rose by 4.7 per cent in the third quarter. 

“To the extent that they were broadly comparable, measures of wage inflation were also considerably higher in the United Kingdom than elsewhere, even though there were signs of easing in all three economies,” the BoE said on Thursday. 

This has supported higher services inflation in the UK than elsewhere. Services inflation is closely monitored by policymakers as a better indication of domestic price pressures than headline price growth.

In the UK it is running at 6.6 per cent, compared with eurozone services inflation of 4 per cent in November and 5.2 per cent in the US.

Though the UK figure has softened this year from a July peak of 7.4 per cent and 6.9 per cent in September, the BoE said the decline had been driven by components such as non-private rents and airfares that are “not typically reliable indicators of trends in inflationary persistence”.

Even the fall in the consumer price index to 4.6 per cent in October was of “relatively limited” significance, the majority of rate-setters concluded. 

The comments were all a very clear rebuff to investors who have been sceptical of the BoE’s repeated claims that rates will be kept persistently high for an “extended” period of time.

Even after the BoE’s latest statement, traders in swaps markets were pricing in at least four UK rate cuts next year.

In an attempt to drive its point home, the BoE repeated its warning that rates could rise yet further and said the decision on whether to hike or hold had been finely balanced. 

The MPC concluded its meeting on Wednesday before the Fed announced its interest rate pivot. The market surge triggered by Powell has made the BoE’s job of keeping UK policy tight harder, analysts said.

The timing of the Fed’s change in policy tack was “unfortunate” as far as the BoE is concerned, said Innes McFee of Oxford Economics. “They want to push back on the easing of financial conditions.”

If the BoE fails to win its argument with the markets that the UK is lagging behind the US in the battle against inflation, sliding yields could drown out Bailey’s tough rhetoric.