BoE likely to hold rates, but publish a weaker outlook

The Bank of England (BoE) will likely keep policy on hold at their meeting this week. It is likely that the current Bank rate of 5.25% is the peak in this cycle. The next move will likely be a cut and happen earlier than markets expect. 

The latest data show that UK Consumer Price Inflation (CPI) was stickier than expected. The big downside surprise in the August release of UK CPI inflation led the Monetary Policy Committee (MPC) to hold rates in September. However, the subsequent release in September surprised to the upside, showing that UK inflation could still remain sticky for some time or only come down slowly. Nevertheless, September UK CPI inflation of 6.7% was still lower than the 6.9% figure the Bank of England had forecast in August. However, wage inflation continues to be very strong and shows no signs of peaking. Since wage inflation is the main ingredient of services and domestically generated inflation, very strong wage inflation readings imply a high risk that CPI inflation will stay significantly above the Bank of England’s target in the medium term. Nevertheless, the Bank of England has started to look through the very strong official wage data in their latest policy statement, relying on other indicators such as surveys instead. Only time will tell whether the surveys, which indicate a decline in pay pressures or the official Average Weekly Earnings (AWE) measure, which hasn’t peaked yet, is the better indicator of underlying pay pressures in the economy.  

To cool wage inflation to levels consistent with target, the Bank of England needs to take the heat out of the labour market. The main reason for these strong wage inflation prints is very strong labour demand against weak labour supply. Vacancies are falling now and the unemployment rate is rising. Despite a major methodological change, the Unemployment rate is still measured at 4.2%, 0.1% higher than the Bank of England expected at this point in the cycle. My calculations show that the unemployment rate will need to rise to at 6.5% for wage growth to return to levels which are consistent with the Bank of England’s target. Output business surveys have improved somewhat on the month, but consumer confidence saw a very large drop in October. Overall, the evidence suggests that the economy is continuing stagnating, but the consumer confidence survey indicates a much faster deterioration in demand.  

These data mean that the Bank of England will likely stay on hold in terms of policy this month. However, the Bank of England will also update its forecasts this month. Given the changes in the data since the last forecast meeting, I believe that the Bank of England could highlight risks of stagnation or recession going forward. Financial markets have only one cut priced in over the next year, which is one of the least aggressive cutting cycles in advanced economies. However, the UK has also had one of the strongest real economy reactions to the tightening in monetary policy. Such a change in projections could serve as an important signal of future policy to financial markets and lead to markets pricing in more cuts into the UK money market curve going forward. I believe that pricing in a larger amount of cuts would be justified given fundamental changes in the UK economy in the past couple of months. The Bank of England could therefore use its projections to indicate that it shares this assessment this Thursday.