Photo by Robert Bye on Unsplash
 

At the Bank of England’s (BoE) first interest rate decision meeting of the year, the Monetary Policy Committee (MPC) revealed that the central bank would hike interest rates for the 10^th time in as many months – raising the base rate by 50bps to 4%.

At the same time, the decision gave the strongest hint yet that the base rate is reaching its peak, the minutes of the meeting revealing that further hikes would only be implemented in the case that there is “evidence of more persistent [inflationary] pressures”.

Then, on the 15^th of February, January’s inflation print from the Office of National Statistics (ONS) showed that the annual rate of price increases had declined by 0.4% to 10.1%. As inflation fell more sharply than the markets expected - despite remaining above the 10% mark - some economists argued that the latest rate hike could be the BoE’s last for some time.

However, significant inflationary pressures continue to impact the UK economy to a much greater extent than the world’s other major economies. Additionally, wage growth in Q4 2022 showed that pay is rising at its quickest pace for over 20 years, while economic growth has slowed substantially as a result of higher interest rates, meaning that the UK economy will shrink in 2023.

As such, many in the world of investment are asking: what will the Bank of England do next?
 

Weighing inflation against growth

With the growth in mind, there are increasing fears that further central bank action risks plunging the UK economy into a deeper, longer recession than is necessary to combat inflation.

So, while it’s important that inflation is brought down in the short term, the BoE must tread a fine line between tightening too much and allowing inflation to become more entrenched for the long-term health of the economy.

After all, the UK only just avoided entering a technical recession last year, with GDP shrinking by 0.5% in December and 0.2% in Q3.
 

Inflationary pressures persist

Despite these growth fears, the BoE will be desperate to bring inflation down to its target of 2% in 2023. This begs the question: what inflationary pressures are the MPC currently grappling with?

An increasingly important factor at the MPC’s interest rate decision meetings is the UK labor market. For much of last year, the upwards pressure on wages was blamed on an increasing crop of vacancies in the UK, and a significant lack of workers. In recent months, however, vacancies have dipped somewhat, boosting the hopes of a rate hike pause at the next MPC meeting.

Official wage data tells another story: statistics from Q4 2022 show that average earnings grew by 6.7% when compared to Q4 2021, demonstrating that this pressure still very much exists. With the data coming in hotter than expected, well-founded fears remain among MPC members that a wage-price spiral could emerge, entrenching inflation to a greater extent. For the BoE to begin considering taking their foot off the gas when it comes to interest rates, they will want to see this inflationary pressure recede in February.

Though harder for the BoE to measure and combat, the effects of large government fiscal packages - like Eat Out to Help Out and the furlough scheme - are to blame for a significant portion of the current rate of inflation. As society reopened, the extra money that consumers were armed with as a result of these schemes and the sharp rise in personal savings resulted in an extraordinary period of economic recovery. At face value, this was very good news – but, when combined with a lack of reliable supply chains, elevated demand created bottlenecks and inflationary prices.

Finally, the BoE will be looking at the cost of energy before the MPC’s next meeting, particularly as these costs represent 26.7% of inflation. Despite the wholesale price for producers decreasing in the last few months, consumer prices remain at record highs, fanning the flames of inflation. Unless we see prices recede for consumers, therefore, the BoE’s hand could be forced into a further hike of the base rate.
 

What will the BoE do next?

Realistically, there are two directions in which the BoE could go.

Firstly, the MPC could decide to pause the rate hiking cycle to help economic growth flourish. After all, those members of the MPC who are worried about tightening the economy too much will see January’s cooler-than-expected inflation rate as a clear indication that it has peaked. Consequently, some analysts predict that the base rate will peak below market expectations at 4.25%. Short Term Interest Rate (STIR) markets are forecasting a 1 in 10 chance of the MPC not hiking rates in March. However, the same STIR markets also see a much higher terminal rate at 4.74% for this year.

For policymakers like Catherine Mann, who said recently that the BoE will not ‘pivot’ to rate cuts any time soon, inflation is still too high to think about reducing the cost of borrowing. Therefore, despite the extra pressure that a further hike would place on mortgage holders and consumers, it’s likely that the BoE is set to try and get rid of inflation for good.

Perhaps for this reason, the markets have priced in a 4.74% peak for November 2023, which will probably give the more hawkish members of the MPC another reason to advocate for more economic tightening, despite the impact it could have on growth. However, after peaking, one would imagine that the BoE would hit a pause to allow for interest rate normalization and greater levels of growth.
 

Opportunities for investors

Around the world, many of the major central bank policymaking committees will also be weighing inflation with growth. As such, many of them will likely tread a similar path to the BoE and hike rates further before pressing pause. Consequently, investors should be on the lookout for currency price volatility in the months to come as central banks hike, pause or cut rates at different speeds, which will create opportunities for trades in the FX markets.

Despite dipping in January, it would be irresponsible to suggest that inflation has peaked when the economic situation remains so changeable. As such, the argument for pausing or cutting the interest rate hiking cycle at the next MPC meeting is not particularly convincing.

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