Sufficiently this, sufficiently that…

What is the MPC considering when judging where rates should peak? 

The August Monetary Policy Committee (MPC) meeting led to interest rates rising by 0.25pp up to 5.25%, as widely expected, and the economic outlook presented in the quarterly inflation report was not too dissimilar from that published in May. The UK is expected to avoid a technical recession, but continue to grow slowly in the near term, while inflation is set to remain above target until Q2 2025 (we are currently projecting that it will take even longer than this to hit 2% inflation).

The last two months of data (June and July) have seen significant drops in UK CPI. Y-o-y CPI rate fell from 8.7% to 7.9% in June and down again to 6.8% in July, owing mostly to a combination of absolute falls in energy prices and prices being compared to very high figures from last year (the base effect). The fall in inflation has been significant enough for real wages to edge into positive territory for the first time since late 2021. This should help prop up disposable incomes at a time of stretched household finances, and might even eventually boost consumer confidence that has been weak for some time now. These weak consumer confidence levels have spilled over into the PMI numbers, which have fallen to the point where a majority of businesses are expecting a recession in the coming 12 months.

Dynamics behind the current process of falling inflation are now becoming clear. Energy (inc. motor fuel, electricity and gas prices) is now contributing negatively to y-o-y CPI, while goods inflation is starting to show promising signs of disinflation as lower shipping costs and supply chain distribution start feeding into prices. On the other hand, the services component of y-o-y CPI, where labour costs are key, continues to creep up and will almost certainly be the reason why inflation remains sticky once headline rate gets to between 4 and 5%.

A quick couple of interesting points made by MPC members at the Bank of England (BoE) press conference following the August decision. First, Ben Broadbent remarked that the impact of rate increases on the mortgage market accounts for “barely a quarter” of the monetary policy transmission mechanism. He emphasised that this was a rough estimate, but his comment would appear to suggest that the MPC is relatively unconcerned about the growth of fixed-rate mortgages leading to major disruption in monetary policy transmission into the economy. 

Second, Dave Ramsden commented on the key metrics that the bank is looking at when making interest rate decisions. He cited three key measures: services inflation, private sector wage growth and labour market tightness. As previously mentioned, services inflation remains stubborn – in large part due to nominal wage growth being very high and not consistent with the bank’s inflation target (average private sector pay is north of 8% in the latest labour market release) – which will of course maintain pressure on the MPC to act. Yet rate setters will also have to take into consideration strong signs of the labour market loosening. For example, unemployment has now risen more than expected in two consecutive months and inactivity levels have been on a downward trajectory since mid-2022. 

August’s and September’s y-o-y CPI figures are likely to show little change, so it will be especially important to scrutinise these metrics in upcoming labour market and inflation releases to gain an understanding of what the MPC may decide to do with interest rates over the remainder of this year. There are, of course, lots of moving parts internationally – not least in China’s banking and property sectors – that have the potential to change the outlook for rates. But for now our forecast is for a further 25bp hike in BoE rates in September. While we note that financial market investors continue to expect the peak to be somewhat higher, we also note that they have been moving steadily closer to our forecast over the course of the summer.  

Daniel Mahoney, UK Economist

All the action came early on in August. Prior to the Bank of England decision on August 3, markets had to digest news that S&P has downgraded the credit rating of the US Treasury from its previous triple A rating to AA+. The debate centred on whether this downgrade was outdated, which the Treasury argued, given the decision was likely related to the saga around the looming breach of the US debt ceiling that was eventually resolved in June. This is probably true, but with deficits growing, increased amount of issuance coming to the table and growing market scrutiny around government budgets (the UK can take the blame for that) it’s justifiable to see markets react to the news.

The main impact was the jump in US Treasury yields, especially in longer tenors, where the 10-year bond yield raced above 4%. Some have argued that the 10-year yield below 4% was too low anyway, as it doesn’t marry up with what markets expect the interest rate path to be, at least by historical correlations. However most expected volatility around the credit downgrade to peter out quickly, and then focus on the medium term which is all about the actions of the Federal Reserve.

The late July decision by the Fed to raise rates by 0.25% but retain its hawkish stance caused no real surprises. The statement commented on the resilience of the US economy, and Chairman Jay Powell referred to the previous forecast that one more hike is likely this year. Despite this markets are still not convinced that another hike is likely with less than 10bps of increases priced in over the final 3 meetings of the year. Data has been mixed, with the jobs market and official GDP data (2.4% growth in Q2) evidencing in some ways the “resilience” the Fed alluded to, there was also a big jump in Consumer Confidence in July. However other survey data, especially the ISM manufacturing and services PMI signal the opposite, with the former’s survey still deep in contraction territory despite a small rise (to 46.4), and a fall in the latter closer to the key 50 mark (52.7 from 53.9) which signals contraction or expansion. The rates market is clearly taking the view that data will disappoint and inflation will continue to trend lower so that the Fed can say its job is done. Now more than ever data is key!

Whilst the market is not pricing a full Goldilocks scenario in the US where the economy remains strong despite rates remain elevated, it’s far from pricing in any real recession either. This “soft landing” approach is keeping longer-term interest rates expectations relatively well anchored, and way off the lows seen in March during the US banking turmoil. There was no change in expectations for rates at the start of 2025 after July’s Fed meeting, remaining around 4% - implying cumulative rate cuts of c150bps over the next 18 months, with the first cut in Q1 next year. This gradual decline in implied rates is also keeping long-term rates elevated as mentioned earlier, and will likely keep the 10-year Treasury yield close to 4.3%.

The story in Europe may be a little more pessimistic from a growth point of view, but the idea of a more gradual path lower in rates also holds. In the short-term it appears the European Central Bank is close to reaching the peak with a rather ‘dovish’ hike in July. The central bank is no longer committing to any future hikes and kept the option of remaining on hold on table. Markets, like in the US are no longer pricing in a full hike in the remaining meetings of 2023. Also like the US, cuts are priced in to begin towards the end of Q1 2024, however the cumulative size of cuts is less at around 100-125bps, and over a longer timeframe of around two years.

No real surprises from BoE

Markets came into the August BoE meeting leaning towards a smaller 25bp hike in bank rate to 5.25%, but they were not ruling out a larger move. Forecasters were rather more unanimous in their call for a smaller move, which is ultimately what the MPC delivered. The committee was split three ways, showing a clear difference in opinion between the hawks and doves. As expected Swati Dhingra voted for rates to stay on hold, whilst on the other end of the spectrum Catherine Mann and Jonathan Haskel voted for a 50bp move. The rest, including new member Megan Greene, voted in a majority for a 0.25% rise. The smaller hike was accompanied by a rather hawkish statement which kept in the phrase that “if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required”. But more crucially another sentence was added that it: “will ensure that Bank Rate is sufficiently restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term”.

The statement was important in many ways as it’s the first time that the Bank of England has labelled policy as “restrictive” which may be interpreted as a sign that the hiking cycle is close to the end. But perhaps more importantly the sentence implies that bank rate will stay at elevated levels for a long period of time. This overall supports the view that we are close to the peak, but the path to lower interest rates will be gradual.

Indeed, the market reaction in short term rates was fairly muted overall. There was a small drop in shorter-term expectations on the back of it with the peak of 5.75% expected to be reached over the course of the next few meetings. Referring back to the June Rate Wrap, it could be that the Bank of England may move out of the ‘jumping’ block to the ‘skipping’ block, whereby they keep rates on hold for a meeting to observe the transmission of the previous hikes into the real economy. Data though is still keeping markets on edge, another jump in average weekly earnings (including bonuses rose at an 8.2% annual rate, excluding bonuses rose 7.8% - both much higher than expected) spooked markets into briefly pricing another hike again taking the peak to 6% in February next year. Even with July inflation coming in more or less in line with expectations, markets are understandably remaining cautious. Yet this all reversed again only a few days later after the dismal PMI number which saw both the services and composite measure fall below 50 indicating a contraction.

The focus now though is what “sufficiently long” means, which is anyone’s guess. Granted it was intended to be vague, but that does not make it any more helpful. Like above though, market angst is playing through in swap rates too where the curve has been on a rollercoaster ride. Rates were up c.30 basis points from the low after the BoE meeting after the wage numbers, In fact, the 10-year segment actually surpassed highs seen back in early July (when markets were pricing in bank rate hitting 6.5%), only to fall back all the way to its August lows after the PMI data. Nevertheless, stripping out the volatility, the theme of ‘higher for longer’ remains.

It will take more persistent bad news, or something to break, it seems before we see long-term rates trending even lower. We have seen a few interesting takes on how this might play out, with the property market a common theme within this. One interesting take from ING (referring to the US housing market) is that it will be the first few rate cuts which trigger a fall in the housing market, as currently prices are stabilising due to a lack of supply. The rationale is that potential sellers will be quicker to react to falling interest rates (and subsequently mortgage rates), putting properties up for sale, compared to buyers entering the market – causing a downturn in prices. One to watch out for, but not a conversation for now.

Another new MPC appointee

As we did with the appointment of Megan Greene a few months back, it is right that we only do the same for the new Deputy Governor, Sarah Breeden, who replaces outgoing Jon Cunliffe on 1 November. She is an in-house appointee as she currently is the Executive Director for UK Deposit Takers Supervision. She is the first internal hire since 2017 when Charlotte Hogg was appointed to the same role as Deputy Governor, only to be in office for 9 days before stepping down after failing to disclose that her brother worked for Barclays.

What is of more importance is what her likely stance will be on monetary policy. The appointment of Megan Greene has been important because she replaced Silvana Tenreyro who was arguably the most dovish member of the committee at the time, only to be replaced with a “centrist” – shaking the makeup of the committee somewhat. This time however, in Cunliffe we are looking at one of the majority voters leaving, and it’s rather unknown what Ms Breeden’s stance is given her focus has mainly been in supervision and macroprudential policy. Some initial comments suggest that it is unlikely she will be at the extremes of the dove/hawk spectrum, and therefore it will be almost a like for like replacement. Nevertheless we will watch out for her opening remarks nearer her start date when she sits in front of the Treasury Committee for any further hints.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg