UK: More front-loaded rate rises, but the UK is not the US
Tomorrow, we expect the Bank of England to raise its policy rate by 25bp - the first back-to-back rate rise since 2004. We now expect three rate hikes this year, up from two previously. While risks to the inflation outlook remain tilted to the upside, however, we think financial markets are pricing in an overly aggressive rise in interest rates.
More front-loaded rate rises...
Tomorrow, we expect the Bank of England's Monetary Policy Committee (MPC) to hike Bank Rate by a further 25bp, following December’s 15bp hike – i.e. the first consecutive rate hike the UK will have seen since 2004. We also expect the Committee to signal that further rate hikes will be necessary in the coming months, with the accompanying release of the Bank’s Monetary Policy Report likely to show an even higher inflation forecast for 2022 (we expect inflation of 4.3% this year), and that inflation would stay above the BoE’s 2% target if rates stay on hold. Our base case from had been that after the February hike, the BoE’s next move come in August. However, given the further strengthening in upside risks to inflation since then, we have now added an additional hike to this profile, which we expect to come at the May meeting. With this, we now expect three 25bp rate hikes this year, at a quarterly pace up until the August meeting, taking Bank Rate to 1.0%. Thereafter, we expect the Bank to shift to a more gradual semi-annual pace of hikes, with two hikes still expected for 2023.
…but the UK is not the US
This profile stands in contrast to that currently priced in by financial markets – with now 5 rate hikes priced in for this year – and it also differs substantially to . Why is this? While the UK economy faces many of the same bottlenecks as the US (as well as some of its own unique Brexit-related ones), and has a similarly tight labour market, we think there are some crucial differences with the situation in the US. First, we are not seeing the same kind of significant excess demand in the UK as we have seen in the US; in fact, retail sales fell sharply in December and are now well below the pre-pandemic trend, whereas in the US they are still above trend following a prolonged period of excess goods consumption. As such, the inflation we are seeing in the UK is still almost entirely a supply-side (and mainly energy and goods) story, whereas in the US there is a significant demand component given the excess consumption we have seen.
Second, and crucial for the medium-term outlook for inflation, is that wage growth in the UK – while elevated – is () well within pre-pandemic ranges, with the recent strength reflecting catch-up from the weakness in wage growth seen early on in the pandemic (see chart below). Indeed, the November labour market report showed wage growth dipping back below 4% on an annual basis. While there are upside risks to the outlook for wage growth given the tightness in the labour market, there are a number of structural forces keeping a lid on wages that will be hard to budge – for instance, significant pay restraint in the public sector (1/5 of the labour force). It looks unlikely therefore that wages will rise faster than inflation itself, and this is what will be needed for inflation to become self-reinforcing over the medium term. Given this, while we expect inflation to remain elevated in the UK over the coming year, price pressure should dissipate substantially in the second half of the year, which should leave the BoE comfortable with a more gradually sloping path for interest rates than markets are currently pricing in.
