MPC reaction: So far, so good. But for how long?

The UK Monetary Policy Committe voted to maintain the Bank at 3.75% at this month’s meeting, in line with consensus and Investec expectations. The vote was 6-3, with the three dissenters – one more than in June – preferring an increase of 25bps. Catherine Mann joined Huw Pill and Megan Greene in the hawkish camp on the committee.

Perhaps unsurprisingly, the key policy issue centred on the risks of higher inflation becoming entrenched via a feedback loop involving higher wage growth. There was general agreement among members that significant disinflation had occurred prior to the conflict between the US and Iran as well as a broad consensus that there had been few signs of second-round effects so far. Disagreements existed however on the extent to which a subdued economy, coupled with loose labour market conditions, would restrain pay growth, bearing in mind that inflation had been above the target almost continuously for more than five years. The hawks favoured a ‘risk management’ approach where an early tightening in policy would reduce the extent of necessary rate increases if wages accelerated. If earnings turned out weaker than feared after all, the hikes, it was argued, could be reversed. By contrast the majority view was that the tightening in financial conditions since the start of the military action around the Gulf provided some insurance against an upsurge in inflation pressures, allowing the committee to seek further evidence on the extent of wage pressures rather than rush to hike. Also it was possible that global energy prices would subside again in the event of a permanent ceasefire between Washington and Tehran, but the risk of the need for higher interest rates at some stage was widely recognised.

The Bank of England’s quarterly Monetary Policy Report was published alongside the decision and the minutes of the meeting. This outlined the MPC’s thoughts in more detail over the outlook and the associated risks. Having relied purely on scenario analyses in April’s MPR without designating any of them as the baseline, the BoE this time restored its central projection which it set alongside a ‘milder’ and an ‘adverse’ scenario. In each case, the analysis was conditioned on the path of rates implied by the yield curve, which equates broadly to two 25bp hikes by mid-2027 with no changes thereafter. The central projection sees inflation rising in the near term due to higher energy prices, but ends up at 1.9% in three years’ time, while in the milder scenario, which includes a modestly lower energy path and no second-round effects (rather than moderate effects as in the central scenario), inflation is at 1.7% at the end of the projection. By contrast inflation is well above the 2.0% target at 2.4% at this stage in the adverse scenario.

Of course the way in which the Gulf-related events play out and how pay growth unfolds are highly uncertain. The various scenarios provide an illustration of the MPC’s views of the inflationary consequences in each case. In his press conference Governor Andrew Bailey played down the hawkish shift in the vote, denying strongly that the MPC was ‘edging towards a rate hike’. Indeed we maintain our view that the Bank of England will avoid raising interest rates this year, keeping the level of the Bank rate at 3.75%. Even so, we recognise that although that there are currently no signs of second-round effects in the labour market, this could change the longer tensions in the Middle East keep energy prices at elevated levels. If this is maintained for too long, at some stage the Bank of England is likely to get jittery about both the dangers of inflation persistence and its credibility if it fails to act in time. We fully recognise the risks of the MPC lifting interest rates later this year, albeit reluctantly.