Signs that UK inflation is finally cooling will not stop the Bank of England raising interest rates to a fresh 15-year high this week, but it could allow rate-setters to slow the pace of tightening, according to economists.
After months of disappointing data, a sharp fall to 7.9 per cent in consumer price inflation in June sparked hopes that UK policymakers were finally winning their fight to restore price stability.
Ahead of the data’s release, investors were betting that the BoE would need to continue rapidly raising the Bank rate from its current level of 5 per cent to well above 6 per cent to return inflation to its 2 per cent target.
Now, hopes are rising that UK policymakers, as well as their counterparts at the Federal Reserve and European Central Bank, could be nearing the end of their tightening cycles. Market pricing suggests that even in the UK, where inflation has persisted at higher levels, rates will peak below 6 per cent.
But the BoE’s forthcoming policy decision rests on a knife edge. Investors view a 0.25 percentage point increase as the more likely outcome, but they still see a significant chance of a second consecutive 0.5 percentage point rise.
“The economy is clearly far too hot for the Monetary Policy Committee to relax,” said Thomas Pugh, economist at the audit company RSM UK. He added that while the slowdown in inflation could “tip the balance” towards a 25 basis point rise, “inflation is far from under control and some members of the committee will see value in sending another strong signal to the market”.
When the MPC last met in June, it said it would be looking closely at the tightness of labour market conditions, the behaviour of wage growth and at services price inflation. If these pointed to “more persistent” inflationary pressures, then “further tightening in monetary policy would be required”.
Since then, the evidence has been mixed. Services inflation has dropped, but less than the MPC was expecting when it last published forecasts in May.
There are signs of the labour market slackening, with unemployment edging higher, vacancies dropping and the workforce starting to grow again. But wage growth has accelerated to record highs to become one of the main drivers of services inflation.
These data “could be deployed to make the case for either a 25 basis point or a 50 basis point [increase],” said Cathal Kennedy, senior UK economist at RBC Capital Markets. He predicted the nine member committee will be split, with the majority voting to slow the pace of tightening, a hawkish contingent favouring a 50 basis point rise, and the dovish Swati Dhingra voting to leave rates on hold.
Andrew Goodwin, at the consultancy Oxford Economics, is among the economists expecting a smaller rate increase, arguing that the change in market expectations “gives the MPC cover to dial tightening down”.
But Dave Ramsden, the only member of the MPC who has spoken publicly since the latest inflation data, struck a hawkish note, saying earlier this month that inflation “remains much too high” and underlining the MPC’s resolve to “address the risk of more persistent strength in domestic wage and price setting”.
If the committee does want to keep tightening policy at pace, however, it will have a tricky task explaining why because the forecasts it will present alongside its rate decision are likely to show that both GDP and inflation will be weaker in the medium term than it expected in May.
This is because the predictions are based on market expectations for the path of interest rates averaged over two weeks in mid July, when they were higher than current pricing and much higher than in May. Sterling has also strengthened since May, while wholesale gas prices have fallen.
This combination means the forecasts are likely to show inflation falling below the 2 per cent target over a two to three year horizon.
“The MPC’s new forecasts will cast doubt on whether interest rates need to rise further at all,” said Samuel Tombs, at the consultancy Pantheon Macroeconomics.
The MPC has played down the significance of such contradictory signals in its forecasts at previous meetings, saying it is now placing more weight on its judgment of the risks to its central projection.
“The committee has moved away from its reliance on forecasting models and is now placing more weight on judgment and risks,” said Philip Shaw, economist at Investec.
After repeatedly failing to predict the persistence of inflation, the BoE has just launched a review of its forecasting process, to be led by the former Fed chair Ben Bernanke.
Analysts think the BoE is unlikely to send a clear signal on how it expects policy to evolve at future meetings — although Paul Dales, at the consultancy Capital Economics, said it would want to “leave the door open to more rate hikes” if warranted by later data.
But Matthew Swannell, economist at BNP Paribas, offered another reason why the MPC might want to act aggressively now, rather than playing for time.
“The BoE only has limited time before it becomes an international outlier,” he said, arguing that both the Fed and the ECB could have finished raising rates by September,” he said.
“With that in mind, the BoE only has a couple of opportunities to tighten rates without becoming the last hawk standing.”
Source: Economy - ft.com
