By Katharine Neiss, chief European economist at PGIM Fixed Income
The UK is experiencing the worst of both the euro area and US inflation drivers – with inflation pushed up by energy price shocks, against a backdrop of an overheating labour market. Unsurprisingly, this is jangling nerves at the BoE.
With the central bank expected to hike at its next meeting, a compelling case can be made for either a 25bp or 50bp increase. Either way, it will take bank rate to its highest level in well over a decade and satisfy a necessary precondition for the central bank to begin active sales of UK government bonds to shrink its balance sheet.
That said, a 25bp hike is the more likely outcome, as the central bank waits to see how its earlier pre-emptive tightening, as well as sharp rise in energy prices, feeds through to the real economy.
Expect a softening in tone to accompany the policy decision reflecting the heightened uncertainty as tensions around the Russia-Ukraine conflict, including the prospect of further sanctions from the euro area, ratchet up.
However, there is a limit to what the central bank can achieve. The UK has been hit by a series of negative supply shocks – Brexit, the pandemic, and now a trade shock due to higher energy prices. No setting of a bank rate can undo these shocks.
Fiscal support needs to be front and centre and do the heavy lifting to generate an offsetting positive supply shock. However, the UK stands out among its peers for fiscal retrenchment at this fragile time.
This puts more pressure on the central bank. That said, accommodative monetary policy is a poor substitute for the lack of fiscal support for stretched households and businesses, so ultimately, we expect rate rises to be capped at levels just above 1%.
