Ahead of the Bank of England (BoE)’s interest rate decision today, Geoff Yu, FX and Macro Strategist for EMEA, BNY Mellon, believes enduring wage growth, tightening mortgage conditions, and sticky inflation mean there are no good options for the central bank:
“The Bank of England’s (BoE) policy decision this week comes with the UK economy in its most febrile state since the mini-budget of last year. The recent strong run of inflation and wage growth numbers has pushed BoE terminal rates close to 6%. Meanwhile, lenders are pulling mortgage deals yet again, and rising mortgage rates could lift household debt-servicing burdens to levels not seen since the 1990s, potentially causing severe economic damage in turn. Consequently, there may be yet another push for the BoE to front-load the pain, reluctantly, to engineer a hard landing, in the hope that it will be short. There would seem no good options but, on balance, we do not see a 50bp or even 75bp point move this week as the ‘least bad’.
Labour market slowing
“The transmission of monetary policy into the economy is not only lagged but also non-linear. The ‘London Buses’ analogy seems very apt here: very little seen for an extended period, and then a significant amount of transmission arrives at once. For example, the wage data is backward-looking and suggests that supply pressures are still tight. However, the real-time data paints a very different picture. As shown below, job openings peaked a year ago and have been on a material decline since January. While we do not expect wage growth to converge to 2.7% (3m average, annualised) during the same time, the current range is clearly not sustainable.
Mortgage market impacting household demand
“The focus right now for UK households, however, is the mortgage market. The rise in swap rates has led to material volatility in product availability, with some major lenders withdrawing and repricing their rates twice in the space of a week. This kind of behaviour constitutes a material tightening in credit conditions and seems sure to have a marked impact on household demand. The mere anticipation of lower disposable income as mortgages reset to a higher level represents a tightening in financial conditions. As opposed to the mini-budget ‘crisis’ of last autumn, there is no supposedly ‘radical’ administration to remove, which could help ‘un-spook’ markets. This time the fears for the economy are patently structural, and with them come the expectations that a hard landing is the only form of mitigation.
“Not only are BoE terminal rates expected to reach high levels, but sticky and structural inflation also reduces the prospects of easing into 2024. That means persistently high household debt-servicing burdens. We believe BoE expectations are close to peaking. Considering that the Eurozone and the US – the key external trading partners for the UK – are also peaking, even with sticky inflation in the UK it is difficult to see BoE rates diverging materially from peers over an extended period of 18 months. As such, we see the risk to BoE easing next year to the more aggressive side, and even more so if the BoE front-loads current tightening to engineer a deeper slowdown in the short term.
Sterling exposures
“This means that markets may also need to be cautious with sterling exposures. Last autumn, terminal rate expectations hit close to 6% as well, but that was after a sharp decline in sterling due to fiscal dominance fears and gyrations in the Gilt market. In other words, higher rates were needed to stop GBP from falling further. But now, as there are no fiscal credibility issues (for now) and the Gilt market is not struggling with anything akin to the liability-driven investment (LDI) shock, normal services have resumed, with the correlation between changes in the currency and swap rates shifting into positive, albeit lightly. Some Monetary Policy Committee members may even conclude that an aggressive hike will help the pound’s cause further and assist with imported inflation on the margins, though we doubt that import prices are currently material to the market’s overall view on inflation drivers.”
