Four scenarios for the Bank of England’s May meeting

The Bank of England sits somewhere between the Fed and the ECB when it comes to tightening monetary policy. As Governor Bailey himself emphasised last week, the UK growth story is much closer to that of Europe, not least because of Britain’s reliance on natural gas a source of electricity. Then again recent UK inflation numbers suggest the wage story has greater similarities to that of the US, where labour shortages are putting ever-increasing pressure on pay – albeit the UK’s experience seems less extreme.

And it’s that latter driver – coupled with some very hawkish language at the tail-end of last year – that has led markets to price in a tightening cycle that’s much closer to that of the Fed than the ECB. Investors expect roughly six more hikes this year.

But that’s getting increasingly difficult to see happening. Our own view is that the Bank will hike next Thursday and again in June, but is more likely to then hold-fire for the rest of the year.

Expect that more gradual message to be reinforced at the Bank’s meeting next Thursday – here are four things we expect.

The Bank has hiked three times so far and a fourth increase next Thursday looks like a near-certainty. The bigger question is whether the BoE opts for another 25 basis-point (bp) move, or whether it follows the Fed and goes for 50bp. At one point last week markets were pricing it as 50:50 either way.

Still, we think 50bp is unlikely. Governor Bailey recently said the Bank is walking a ‘narrow path’ between growth and inflation, and implied that the Bank was comfortable with taking a more phased approach to tightening. Of course the BoE is at a slight advantage to some other central banks in that it already has a few hikes under its belt.

And while fellow committee member Catherine Mann didn’t close to the door to faster tightening in a recent speech, she implied that much would depend on how quickly the consumer story deteriorated. It’s still early days, but last week’s plunge in consumer confidence and second-consecutive fall in retail sales suggest caution.

Even before the war in Ukraine, the Bank was expecting persistently high inflation but a bleak growth outlook. New forecasts due next week are likely to show that this trade-off has only magnified since. Energy prices are higher – and remember that the BoE assumes gas prices stay flat beyond six months in its projections, so the new inflation numbers will ignore the fact that futures prices edge lower beyond next winter.

Meanwhile, markets expect the Bank to hike rates to roughly 2.5% over the next year, which amounts to roughly 100bp more tightening priced in than before the February meeting.

The net result is likely to be an inflation forecast that peaks around 9% in April and stays not far below that throughout 2022, and an economic outlook that features at least one quarter of negative growth this year. Like February, we also expect the BoE to project a rise in unemployment over coming years.

If we’re right, then this should be read as a hint that market pricing has become too aggressive and investors should prime themselves for fewer rate hikes.

Ever since the Bank began hiking late-last year, we’ve felt that the committee would probably become more divided on the need for further tightening as Bank rate ratcheted higher.

That theory looked severely misplaced after four out of nine committee members voted for a 50bp hike back in February. But since then, we saw one official – Jon Cunliffe – vote for no change in rates at the March meeting, explaining subsequently that he was less fazed than others by the rise in consumer inflation expectations.

We suspect next week’s vote split will be 8-1 again in favour of a hike, but if the dissent becomes more widespread then that would be another hint to markets that the rate hike cycle could be nearing a pause.

The Bank kick-started its quantitative tightening (QT) process back in February, and has previously signaled that this could be accelerated by actively selling government bonds back into the market. We recently argued that the rise in market volatility suggests now is not an opportune moment for the Bank to start doing this. And instead, we simply expect to get some further details on how such a policy could work in practice, not least the mechanics of how the sales might be conducted.

Assuming market conditions improve, there’s still a fair chance the Bank will start selling bonds within 9-12 months. Without sales, the BoE’s balance sheet is going to decline at a very slow pace.