The Bank of England (BoE) was one of the first developed-market central banks to ring the alarm bells on inflation when it started hiking interest rates and ended quantitative easing (QE) at the end of 2021. Despite that early mover advantage, the Bank faced enormous scrutiny for falling “behind the curve” in recent months as events beyond the UK’s borders derailed its normalisation path.
However, the Bank’s 50 bps rate hike to 1.75% as well as its signal that it may sell its gilt holdings in September put it back on track and in good stead to control inflation. As the central bank faces a thorny stagflation scenario, its path offers a useful case study for other late-moving central banks.
A Sobering Economic Outlook…
The UK’s strong post-pandemic recovery, thanks to positive policy support measures, had been its saving grace. But a succession of negative shocks – Brexit, the pandemic and rising energy prices – is creating huge uncertainty to the outlook.
Indeed, the Bank’s policy decision was accompanied by a sobering economic update: it expects inflation to peak at 13%, before the economy falls into recession by the end of the year.
Hints of the weakness ahead are beginning to emerge. Domestically, unemployment has stabilised and job vacancies have started to decline. Surveys show that consumer demand is weakening. In addition, the slowdown in the European Union, the U.S. and China is expected to spill over and weigh on the UK economy.
… With the BoE Back on Track
The BoE’s proactive stance should put it in good stead in terms of bringing inflation under control. But, at some point, economic support will also clearly be needed., which could limit further rate hikes as the Bank pauses to assess the impact of the energy shock and cumulative rate rises on the economy. Therefore, rather than additional rate hikes that risk exacerbating an undesirable economic situation, we expect the BoE to pivot its policy tightening and prioritise a more active run-off of its balance sheet that could also address lingering market anomalies.
Therefore, if inflation remains within the Bank's forecasts and the Bank’s balance sheet contraction translates into tighter financial conditions, we anticipate the base rate might remain below the 3% expected by the market.
That said, the UK is an open economy, and additional rate hikes by the Federal Reserve could prompt further depreciation in sterling vs the dollar. That, in turn, could add to UK inflation, push the BoE to tighten more than warranted, and further weaken the domestic economy.
Strength in the U.S. dollar historically leads to anticipation about its effects on commodity prices and the prospects for the emerging markets. However, as monetary policy rates diverge and Europe’s energy crisis intensifies, the dollar’s significant appreciation against the Japanese yen and the euro points to an extending chain reaction. In particular, this post looks at how the ECB may find itself in a situation more akin to emerging market central banks as it faces historically elevated inflation alongside mounting economic uncertainty.
Market Technicals Matter
The BoE appears to have got its early timing right when it shifted policy last December. But after six hikes, sterling has depreciated over 10% vs. the U.S. dollar and inflation has accelerated to 9.4%, far beyond the Bank’s 2% inflation target. Where did it err in tackling inflation?
An overly gradual hiking cycle may be one reason why the BoE has found it difficult to achieve its objectives. But market technicals matter, too. As part of the BoE’s QE program, the Bank bought most of the available gilts with 0- to 10-year maturities. That made these bonds scarce with poor liquidity.
As a result, dealers found themselves forced to borrow these scarcer gilts from the UK’s Debt Management Office (DMO) through the DMO’s so-called “Standing Repo Facility”. Narrow supply in the open market made the bonds dearer, and it held back yields—lessening the effect of the Bank’s rate hikes.
To make matters worse, the DMO has also been widening the spread over base rate at which it lends these in-demand gilts (see figure 1). That made it even more expensive for market participants to source them. It made UK gilts unattractive from a global investment perspective, thus further weighing on sterling and feeding through to inflation. Since the June BoE meeting, the DMO has capped this spread at 75 bps, which has taken some pressure off of the currency.
Figure 1
The DMO’s “Standing Repo Facility” Spread Vs. the GBP/USD Exchange Rate
DMO, Bloomberg.
Conclusion
To effectively fight inflation, the BoE has reached the time when it can rely more on active quantitative tightening QT and less on rate hikes. A first step arrived when the DMO left its standing repo facility spread over base rate unchanged at 75 bps. The latest 50 bp rate hike was another step in the right direction, as the Bank announced that it is targeting £10 billion of gilt sales as a start of active QT, which should raise bond yields and facilitate the transmission of monetary tightening on inflationary pressures.
While the Bank of England faces what can only be described as stagflation in the months to come, it provides some lessons for central banks that are either slow moving or find themselves at an equally challenging crossroads. Although the inflation fight is clearly the priority amongst most major central banks, tightening policy with market impediments in place can thwart efforts to rein in prices. Hence, it’s critical to address those blockages to policy transmission as it also removes pressure to hike rates further when the respective economy is already staring into the abyss of stagflation.
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