Bank of England rate decision - what to expect on Thursday

Our head of investment comments on the expected interest rate hike, inflation, and the possible market reaction.

ANOTHER HIKE EXPECTED 

The Bank of England is forecast to raise interest rates for the 14th time in a row on Thursday, lifting the bank rate to fresh 15-year highs.

While expectations are for the central bank to lift the current bank rate from 5% to 5.25%, there is still a chance it could opt for a more aggressive 50 basis point move to 5.5%. Even a 25-basis point increase, however, would lift borrowing rates to the highest level since March 2008 but would mark a slowdown from June’s half a percentage point hike.

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VOTE SPLIT

The Monetary Policy Committee’s decision is unlikely to be unanimous with policymakers divided over the extent to which the BoE needs to tighten monetary policy further to rein in inflation.

New external MPC member Megan Greene, who will cast her first vote this week, is seen as a more hawkish addition to the committee than her predecessor Silvana Tenreyro, who voted against recent rate increases. Greene has warned against ‘start-stop monetary policy’, which she says could mean ‘you may end up having to tighten even more.’ Meanwhile, dovish member Swati Dhingra, who has been voting to keep rates on hold since December, is likely to do the same again on Thursday.

TERMINAL RATE

In June, markets were anticipating the bank rate would peak above 6% in February 2024. However, considering recent data, economists are now looking at a terminal rate of around 5.75%.

According to a recent Reuters poll of 14 gilt-edged market makers, 11 expect at least 75 basis points of further tightening by the end of the year. Several of Britain’s biggest lenders including Nationwide, Barclays and HSBC cut their fixed mortgage deals last week, suggesting the end of the rate hiking cycle could be in sight.

INFLATION

Peak cycle forecast reductions have been driven by the latest UK inflation figures which saw price pressures finally start to ease.

CPI inflation dropped to 7.9% in June, the lowest level since March 2022 and below consensus expectations for 8.2%, driven by a drop in energy prices. Core inflation, which strips out some of the more volatile components, also eased back to 6.9% from 7.1% in May. However, inflation remains sharply above than the Bank of England’s 2% target and is still perilously high by international standards. By comparison, US inflation eased to 3% in June and Eurozone inflation fell this week to 5.3% in July.

According to Kantar, food inflation, which has been particularly sticky, improved significantly in July to 14.9% from 16.5% in June, although clearly remains far too high. Several supermarket bosses have suggested we’re beyond peak inflation, providing further reason for optimism ahead.

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Considering second-round inflationary effects from the labour market, data last month saw British wages rise at their fastest pace on record. Basic pay in the three months to May increased by 7.3%, outpacing forecasts for 7.1%, raising concerns about one of the central bank’s biggest fears, a wage-price spiral.

However, the unemployment rate unexpectedly rose to 4% in the three months to April and job vacancies between April and June slumped for the 12th consecutive time, suggesting that tighter monetary policy is starting to have a dampening effect on the economy.

After June’s decision, Chancellor Jeremy Hunt said inflation is the ‘greatest immediate economic challenge’ we face. And in July, the Bank of England’s deputy governor Dave Ramsden said CPI inflation has begun to fall significantly but remains much too high.

QUARTERLY PROJECTIONS

Accompanying the rate decision, the Bank of England will deliver its quarterly Monetary Policy Report, laying out the economic analysis and inflation projections used by the MPC to reach its decision.

In May, the central bank issued its biggest ever upgrade to its growth forecasts and said it is no longer expecting the UK to enter a recession. This is a major U-turn from its expectation last November when it warned of the longest downturn in a century. However, some argue that a recession is the only way to tackle the UK’s persistent inflation problem.  

Official figures from the Office for National Statistics saw UK GDP contract by 0.1% in May, better than expectations for a drop of 0.3%. Year-on-year, the economy shrunk by 0.4% also better than forecasts for a drop of 0.7%. The takeaway is that the UK economy is proving to be much more resilient than many had anticipated. However, Prime Minister Rishi Sunak’s new year pledges to grow the economy and halve inflation will be tricky to achieve by December.

MARKET REACTION

After softer-than-expected inflation data last month, the pound sold off. But above-target inflation and monetary policy tightening mean that sterling has still strengthened over the past two months. A more hawkish than expected hike on Thursday would likely provide significant support for the British currency, whereas if the BoE’s inflation projections suggest price pressures will cool significantly ahead, the pound could reverse some of its recent rally.  

The FTSE 100 enjoyed a strong performance in July, rallying on the back of softer domestic inflation indications. Any suggestion that the rate-hiking cycle is approaching the end could boost risk-on sentiment and in turn UK equities, particularly the FTSE 250, which is a closer barometer of UK economic strength than the blue-chip index.