The era of the hawkish pause
The Bank of England followed the Federal Reserve and paused their interest rate hikes this week, although both banks indicated that further rate hikes could be coming and that the fight against inflation is not over. The Fed’s (non) move was expected, however, the BOE’s decision to pause was only anticipated after the weaker than expected inflation reading for August. The question now is whether we are at the peak for this rate hiking cycle, and what that means for markets. The decision at the BOE was tight, and there was a 5-4 split of the 9-person MPC in favour of keeping interest rates on hold. While the Fed seemed more unified in their decision on Wednesday, the decline in US jobless claims on Thursday, to 201k last week, from 221k the week prior, which is one of the lowest levels since before the pandemic, increases the chances of further rate hikes in the US, which is hurting US growth stocks such as the Nasdaq on Thursday.
Thus, the path of monetary policy from here is unclear, so it seems a pause in rate hikes, to see how monetary policy tightening will play out in the coming weeks and months, is a sensible move from both central banks. Below we look in detail at the BOE decision, and the market reaction.
BOE: when will monetary policy be sufficiently restrictive?
· The split: this was the most noteworthy aspect of this meeting, since the 5-4 split shows how close this decision was, and it also highlights how neither the doves nor the hawks have the upper hand. However, it also shows the hawks’ resolve not to take their eye off the ball, even when the August inflation report showed price growth continuing to fall.
· The 4 members who voted to hike rates to 5.5%, did so because of these four factors: 1, real household incomes are rising and forward looking indicators of economic activity had remained positive, 2, the labour market was still tight and wage growth was strong, 3, the fall in service price inflation was driven by volatile components and had followed recent upside surprises, 4, another hike is necessary to ensure that inflation does not get embedded into the economy.
· The newest member of the MPC, Megan Greene, voted to hike rates which means a dovish member has been replaced by a hawk.
· The reasons given in the MPC statement to keep rates on hold are different from the reasons why 4 members decided to vote for a hike in rates. This suggests that there is robust debate at the bank, which muddies the path for the future monetary policy decisions.
· The statement said that the labour market is loosening slightly, average wage growth is picking up, however, this is higher than other measures of wage growth and thus may be unreliable.
· There is evidence that recent rate increases are having an impact on inflation and economic activity.
· Inflation is expected to return to the 2% target rate within the 2–3-year horizon period.
· Even if the BOE did not hike on Thursday, MPC members noted that monetary policy needs to be sufficiently restrictive to return to the 2% inflation target. This suggests that rate cuts are a long way off.
Interestingly, while the BOE mentioned the increase in oil and gas prices – which have risen by 17% and 26% respectively since the August meeting - they did not sound worried about these developments. The surge in the gas price is down to strike action at an Australian LNG facility, while the rise in the oil price is down to supply cuts from Opec + members Russia and Saudi Arabia. In fairness, the BOE cannot control either of these things, so it is understandable that they did not dwell on them. Also, higher commodity prices do not feed directly into inflation rates, as multiple factors are at play. However, $100 oil is likely to have an inflationary impact at some stage, so we were slightly surprised that the BOE did not place more emphasis on the upside risks energy supply constraints could have on the inflation outlook, especially when the BOE is still happy that the 2% headline inflation target will be met by Q2 2025.
The BOE also said that further monetary policy tightening will be necessary if there is evidence of persistent inflationary pressures. This means that future BOE decisions will be based on economic data, so we expect the pound, UK gilts and interest rate swaps to remain highly sensitive to inflation and labour market data in the months ahead.
The market impacts
The BOE meeting had a large and swift impact on financial markets, although some of these moves had slowed as we progressed through Thursday’s afternoon session. GBP/USD lost the $1.23 handle but stayed above key support at $1.2250. The surge higher in US bond yields on Wednesday evening has not had a lasting impact on the dollar. US 2-year bond yields are slipping on Thursday, and after jumping to nearly 5.2%, they are now down 8 basis points. The dollar index is flat on Thursday, and it appears that another central bank taking the decision to remain on hold has boosted the yen, ahead of Friday’s BOJ meeting. If the BOJ announce any further tightening measures, then the move higher in the yen may continue.
Bond yields across the UK Gilt yield curve moved higher, although some of the gains in yields moderated as we progressed through the afternoon. The clear gainers in the UK stock market space were consumer stocks, including JD Sports, Frasers group and Next. Lower rates of inflation and a central bank on pause is a heady mix for consumer stocks and property developers right now.
Market-based interest rate expectations also fell after the MPC meeting, with the peak in interest rates now expected to be 5.37% in March 2024. This means that there is a roughly even chance of another rate hike in the next 6 months. Unsurprisingly, no rate cuts have been priced in by the market, and interest rates are expected to remain at 5.29% by June 2024 and only 5.20% by August 2024.
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