Bank maintains Base Rate at 3.75%, but three rate setters now back a hike
Today, the Bank of England Monetary Policy Committee (MPC) left the Base Rate unchanged at 3.75%, meeting financial market expectations and mirroring the decision on Wednesday of the US Federal Reserve. A notable development was the increase in the number of dissenters on the MPC who voted for a 25 bps increase, which increased to three, up from two in June. This shows the mood on the committee has shifted towards caution, which will fuel expectations that at least one 25 bps Base Rate hike is coming this year, perhaps even two.
This more hawkish mood almost entirely relates to the war in the Middle East and its impact on energy prices, as the MPC acknowledged that most of the indicators for the UK economy itself have been better than expected lately. CPI inflation declined in June, and at 2.6% was lower than expected. GDP data for May reported a return to growth of 0.1% month-on-month, following April’s contraction of -0.1%. Meanwhile, pay growth in real terms has fallen to marginal levels, while job vacancies are low relative to the number of unemployed, and both factors reduce the danger of inflation being driven up by a wage-price spiral.
This is not an economic backdrop which would normally prompt any discussion of raising interest rates, but the elephant in the room is the war in the Middle East, which has driven up the oil price. In the press release accompanying today’s rate decision, the MPC observed: “Monetary policy cannot influence energy prices but is being set to ensure that the economic adjustment to them occurs in a way that achieves the 2% inflation target sustainably. The policy stance required to achieve this will depend on the scale and duration of the shock, and how it propagates through the economy including via financial conditions.”
The underlying message from the MPC is: if high oil prices persist, and evidence emerges of ‘second round effects’ (where elevated inflation prompts demands for bigger pay rises by workers, fuelling an upwards spiral for prices) the Base Rate will have to rise. However, the MPC by leaving the Base Rate unchanged acknowledged we have not reached that point yet. Indeed, with the 10-year gilt yield at 5.0%, the majority of the committee feel there is no need to do anything that will further increase market interest rates.
So, the current situation for the UK economy could be described as: ‘The Good, the Bad and the Ugly’. It is good that most UK economic indicators have held up relatively well this year given a war is being fought across one of the most critical shipping lanes in the world (the Strait of Hormuz). It is bad that the Middle East war is continuing and driving yet another upswing for oil and gas prices. However, the ugly truth is the relatively stable economic conditions we have seen up to now will not continue if the war runs and runs, as that will force the majority on the MPC to support hiking rates.
Consequently, on the economic and interest rate outlook, much now depends on whether one side in the Gulf War is getting ready to climbdown, something which is impossible to know. We note that November’s US midterm elections are drawing nearer, petrol prices in the US are high, and President Trump’s approval ratings are low. This should count in favour of Trump seeking a peace deal soon, but the current US President is such an erratic character it is unwise to make assumptions about his next move.
There are though some silver linings to this geopolitical cloud over the economy.
First, the fundamentals of the UK economy, contrary to the line being pushed by some politicians and pundits, are holding up surprisingly well, and even compare favourably to some other advanced economies. For instance, inflation is lower in Britain than in the US or the Eurozone, which is the opposite of what was being predicted when the war broke out.
Second, the MPC does not appear to be in any hurry to raise interest rates, which is welcome because if the opposite were true it would send a deeply negative message to investors at home and abroad. Indeed, the Bank of England today published forecasts that predicted UK inflation could fall below the 2.0% target level in 2028 and 2029, which is a strong hint from Threadneedle Street they believe some are overdoing the inflation fears.
Third, if we consider alongside each other a USA with an unpredictable leader, instability in the Middle East and Eastern Europe, plus volatility in equities, bonds and commodities markets, one suspects UK property’s appeal as a safe haven investment will be high this autumn, especially for prime real estate assets in core markets.
