Domestic Bonds

Four things to watch for at the Bank of England rate-setting meeting

In what is the most anticipated monetary policy meeting in years, the Bank of England will announce its latest interest rate decision this week along with new forecasts for the UK economy.

The last BoE interest rate meeting on September 22 just preceded one of the most turbulent periods in recent UK economic history. Liz Truss’ ‘mini’ budget involving £45billion in unfunded tax cuts has sent government borrowing costs skyrocketing, triggered an emergency BoE intervention and led to higher mortgage rates for homeowners.

New Prime Minister Rishi Sunak promises a new economic strategy in the government’s November 17 autumn statement, focused on lowering debt as a percentage of gross domestic product over the medium term.

The BoE’s monetary policy committee, by not having all the details on Sunak’s strategy, will therefore be largely “blind” when it unveils its decision on interest rates on Thursday. Below are four things to watch out for.

The interest rate decision

The nine MPC members will vote on how much to raise the official overnight interest rate from its current level of 2.25% in response to high inflation.

Financial markets are betting on a 0.75 percentage point rise to 3%, which would be the biggest rise since 1989 and take it to the highest level since the 2008 global financial crisis.

An increase of this size would be in line with the European Central Bank’s interest rate hike last week as well as expectations for the Federal Reserve’s likely decision on monetary policy on Wednesday.

UK economic data has not changed much in the past six weeks, with inflation at 10.1% in September, its highest level in 40 years, and a still buoyant labor market, but surveys on the business activity weakened sharply.

The central question is to what extent Sunak’s government plans immediate tax hikes and spending cuts, in steps that would pull money out of the economy and ease inflationary pressures. Such actions would weaken the need for a sharp rise in interest rates now.

While much of Sunak’s fiscal tightening is expected after the next election, which is expected to take place in 2024, the MPC would want to take strong action against inflation immediately.

As BoE Governor Andrew Bailey warned this month, the central bank will be “flying blind” as the government has yet to make any major decisions on public finances.

Reflecting these uncertainties, the majority of economists expect MPC members to raise the Bank Rate by 0.75 percentage points on Thursday.

Samuel Tombs, an economist at Pantheon Macroeconomics, said he expected “the MPC to raise the Bank Rate by 0.75 percentage points, but signal smaller increases in future meetings.”

Managing monetary policy expectations

As important as Thursday’s interest rate decision will be the signals the MPC sends on the likely future path of monetary policy once the government releases its fall statement.

Most economists believe the BoE will try to persuade markets that it doesn’t have to raise interest rates as high as they currently expect. Traders are betting on rates peaking at 4.75% in the summer of next year.

Line chart of the BoE's expected interest rate (%) showing that market expectations for interest rates have fallen, but still suggest strong increases ahead

Earlier this month, Ben Broadbent, the BoE’s deputy governor for monetary policy, cast doubt on markets at the time, setting rates above 5%, saying that would cause a recession that would be deeper than needed to bring inflation down to the central bank’s 2%. cents goal.

Ross Walker, an economist at NatWest, said Broadbent’s “skeptical market prices of . . . discount rate above 5 percent” was important in his forecast that rates would peak at 4.25 percent.

Economic growth and inflation forecasts

In August, the BoE shocked the nation by predicting inflation hitting 13% by the end of 2022, a prolonged recession and the worst squeeze on living standards in 60 years.

As the government caps household energy bills to limit price increases in the short term, the BoE’s inflation forecast could be revised downwards. But the central bank is still expected to suggest the economy is heading into a recession later this year.

The forecast is exceptionally difficult for BoE officials to piece together, as the government’s tax and spending policy is unclear amid volatile markets.

To support its forecasts, the BoE normally uses market prices – including expectations of future interest rates – over a 15-day period that expires just over a week before an MPC meeting. Compared to the November 3 meeting, this period would include the aftermath of the “mini” fiscal turmoil, making the forecast appear worse than it should be.

BoE officials will therefore have to choose to abandon normal BoE forecasting conventions to produce forecasts that reflect the recent calm in the markets.

Andrew Goodwin, an economist at Oxford Economics, said there was a good chance the BoE would “examine” such quirks in its forecasting conventions to produce forecasts more useful in explaining central bank policy decisions.

Quantitative tightening

In September, the MPC agreed that the BoE would sell government bonds it had bought in waves of quantitative easing to stimulate the economy after the financial crisis and the Covid pandemic.

The BoE proposed to reduce the stock of bonds by £838 billion at a rate of £80 billion over the following year, in order to reduce the central bank’s balance sheet.

But the plan was derailed by the turmoil that followed Truss’ ‘mini’ budget, when the BoE had to step in to buy up to £65bn of long-dated gilts to shore up parts of the pensions sector threatened with insolvency as yields rose sharply.

The BoE announced this month that it would begin its bond sale in November, with a focus on short- and medium-term gilts. He said he would refrain from selling long-term bonds.

Sanjay Raja, an economist at Deutsche Bank, said he expected the MPC on Thursday to “confirm its commitment to active quantitative tightening”.