Bank of England Raised Rates by 0.25% & Uncertainty Around the Outlook Persists

Small Hike

The Bank of England started its tightening cycle all the way back in December 2022, but has failed to bring inflation under control. In June it was forced to reaccelerate the pace, but opted today for a smaller 0.25% increase. ^[1]

This was the fourteenth straight move, which brought rates to 5.25%. The central bank now judges that the current policy stance is "restrictive", given the cumulative tightening, which amounts to 515 basis points.

Going into the meeting, there were diverging expectations around the size of the rate adjustment, but the downsizing did not constitute a surprise. Divisions amongst policymakers were evident in this meeting as well, since there were three dissenters, voting against the majority. Two of them voted in favor of bigger 50 bps move, whereas the other member preferred for rates to remain unchanged.

High Inflation & Wages

The high cost of living continues to trouble households in the UK, the level of which has repeatedly surprised policymakers. The last CPI report offered a glimmer of hope and allowed them to deliver a smaller hike today. Headline inflation decelerated further to 7.9% y/y in June, while Core eased from its thirty-one years highs to 6.9% y/y.

Despite these positive signs, inflation remains far from the 2% target and even though officials expect it to "fall significantly further", they upgraded their 2024 forecasts. Headline CPI is now projected at 2.5% in 2024 (from 2.25% previously) and is not expected to fall below 2% before Q2 2025.

Furthermore, the labor market "remains tight", despite some signs of easing. More importantly, wages are very high, making efforts to bring down inflation much harder and create fears of a wage-price spiral. Governor Bailey had warned last month that "both price and wage increases at current rates are not consistent with the inflation target". ^[2]

Uncertain Outlook

The bank's communication skills are very poor and once again, it refrained from offering any insights as to its next steps, while the tree-way split vote only adds to the uncertainty. Inflation retreats, but is not expected to hit the target for another two years. This makes it hard for the BoE to back down. Furthermore, today's forecasts are based on a terminal of 6%, from current 5.25%.

On the other hand, they need to tread carefully as rate hikes work with a lag and as the already massive amount of tightening stresses households and business. In its Q2 Financial Stability Report, the central bank alluded to these pressures from "higher borrowing costs". Risks of a mortgage crisis are rising, with the BOE estimating that a typical mortgagor would see the interest rates payment increase by £220 over the second half of the year, when rolling over a fixed-rate deal. ^[3]

Market Reaction

Market reaction was somewhat limited, as the move was not a surprise. The smaller hike and the lack of forward guidance pressured GBP/USD. The road to more hikes remains open and that could support the pound, but rising risk of the BoE breaking something, means that further tightening may not necessarily be beneficial.