Will the Bank of England change interest rates?

The Bank of England’s Monetary Policy Committee will announce its latest policy rate decision next Thursday at midday. We expect that it will keep the Bank rate on hold once more, at a rate of 3.75%, the same level it has been set at throughout this year so far. Markets too are pricing in only a slim chance of a hike this time, of just 11%. As is very much the norm on the MPC, we anticipate that a minority of MPC members – Megan Greene and Huw Pill, and potentially another one of their colleagues – voted for a 25bp rate hike instead. A more detailed explanation of the backdrop and analysis underlying the decision will be provided in the accompanying Monetary Policy Report (MPR), and there will also be the usual post-MPR press conference by Governor Bailey and some of his colleagues.

Since the last MPC meeting, there have been a number of important developments. Domestically, this includes the appointment of Andy Burnham as Prime Minister. But in the context of the upcoming MPC decision, this is unlikely to have a major impact: the policy changes announced so far (the removal of VAT on electricity bills, for now only temporarily) are helpful at the margin for the inflation outlook but ultimately small beer, not a gamechanger. This could well change in the future – what is announced at the Budget could well be more impactful. And of course, ultimately, if Burnham were to achieve his ambition of ‘good growth in every postcode’, this would change the path of monetary policy too. But for now we expect the MPC to disregard the change of PM and cabinet.

The main topic instead is the Iran war. The situation is still very fluid and could easily have taken a turn for the better or for the worse by the time of the MPC decision. But as things stand, since the last MPC meeting, the big picture is that the MoU between Iran and the US has broken down following disagreement of who is to control the Strait of Hormuz. This has squeezed the amount of crude oil and natural gas available to global markets. With that, energy prices have rebounded sharply. And the export ban on diesel by Russia, following attacks by Ukraine on its infrastructure, has tightened the screw on global supplies of some distillates even further. Ultimately, therefore, the crucial debate will centre on whether or not this situation warrants monetary tightening by the MPC.

Fundamentally, the arguments on either side look similar to last month. The doves on the committee can point to recent data: inflation has in fact been more benign than the previous MPR’s baseline forecast had anticipated – mainly because of lower food and, to a lesser extent, energy prices, but importantly also on slightly softer goods and services prices. Likewise, wage growth seems, if anything, a tad weaker than the MPC had expected back in April. And although headline GDP growth looks to be tracking visibly firmer than forecast, the MPC has recently placed more weight on its own gauge of ‘underlying’ GDP growth, which is informed by business survey data; the PMIs, for one, signal softer activity than the official GDP data. Governor Bailey, who has not advocated a rate hike so far, set the hurdle to switching positions quite clearly.  He said he 'would respond promptly to any signals that an extended period of elevated energy prices could be leading to stronger possible second-round effects'. The above data is unlikely to persuade him that a hike is needed now. On top of that, the argument will likely run, most MPC members consider the current policy rate to be already restrictive, and the recent run up in longer-dated borrowing costs itself tightens financial conditions.

The hawks on the MPC, meanwhile, have made their argument more in a risk management framework. It seems very likely that the escalation of the Iran war, for them, pushes up the probability of a scenario where energy costs persist at higher levels for long enough to filter through to wages and other prices. Indeed, they may well point out the risk that, with every day that world inventories have to be drawn on to plug the gap between energy demand and supply, the ‘pinch point’ at which usable energy stocks are depleted draws nearer. If and when it is reached, energy prices may need to rise much further to bring demand in line with even lower supplies. They are likely to once again argue the case that a pre-emptive hike to manage the risk of above-target inflation persisting unnecessarily long is the more prudent course of action. Finally, we expect them to stress that, unless policymakers deliver on the rate hike expectations embedded in market pricing, tighter financial conditions will unwind again of their own accord.

Bringing this all together, we think a lively debate on the MPC will continue. On balance, we think the majority of its members will conclude that the hurdle to act is not reached, taking comfort from the still benign wage and core inflation figures. But the longer the Iran conflict continues, the more nervous MPC is set to become. The MPC is in a similarly uncomfortable position to the FOMC, having not met its inflation target on a sustained basis for a number of years. As Fed Governor Waller put it recently ‘sternly staring at inflation until it melts before our withering gaze is not an option’. The same sentiment must be nagging at MPC members too. Our baseline forecast assumes that there will be a durable resolution to the Iran conflict soon, and with that we think the MPC will be able to hold out and not hike this year. But with each day of squeezed energy supplies, it is getting a closer and closer call.