The big questions facing the Bank of England

Adverse scenario?

The rise in oil prices means the UK has entered what the Bank of England set out in July as its 'adverse scenario', a situation that could see headline inflation peak at 4%, raising the likelihood of a broadening in inflation beyond energy and potentially substantiating 4 rate hikes. Market pricing in in this ballpark but I think it's not going to happen. The context of the BoE policy meeting is tough - rising bond yields, a surge in oil price and likely rate hikes by the Federal Reserve and Bank of Japan on top of the European Central Bank's hike on Thursday. We'll get some answers in the next few days with labour market data (Tue) CPI inflation data (Wed) and the Bank of England rate decision (Thu).

Is the UK labour market improving?

"Payrolls down, vacancies down, wage growth coolest in six years...UK labour market data was once again weak and shows there is no reason for the Bank of England to raise interest rates. The risks are clearly skewed to the downside in terms of the economy more than they are skewed to the upside on the inflation side."

That's what I wrote on 18 August, after the latest UK labour market report from the Office of National Statistics. Unemployment had risen to 4.9%, while vacancies fell below pre-pandemic levels

But could things be turning around? Latest ONS figures for the UK labour market are due out on Tuesday and will be closely watched ahead of the Bank of England later in the week.

The latest survey of UK recruitment consultancies signalled the first broad-based improvement in hiring activity for nearly four years during August, according to the KPMG/REC Report on Jobs data, compiled by S&P Global.

The labour market is no longer generating the intense wage pressures that worried the BoE in recent years. Employment remains broadly stable, but wage growth is cooling, easing the pressure on the BoE to raise rates. While the GDP report won't have moved the needle for the BoE, the employment report will be watched for how much scope the BoE might have should the inflation picture darken.

Is UK inflation going to top out below 4%?

With the soft labour market on the one hand, on the other there is the question of whether the Bank of England actually needs to hike since inflation is not currently expected to get out of control.

On Wednesday the next CPI inflation report is due. Last month's CPI data showed the headline inflation rate rising from 2.6% to 2.9%, largely due to a 13% increase in the energy price cap. Although inflation did rise it looked like underlying trends were sufficiently benign give the Bank of England breathing space. Food inflation was at a five-year low and the important services inflation rate ticked lower to +3.4% from 3.6%. Since then BRC shop price inflation rose to 1.5% in August from 0.9% in July, the highest since February 2024. Meanwhile there are warnings from industry that food inflation will rise above 6% next year as wars and El Nino plus more regulatory costs force up prices. Meanwhile the flareup in the Middle East in the last week will exert additional pressures on headline inflation in the next few months, beyond perhaps what has been forecast.

Bank of England's own models suggest second-round start to bite once inflation hits 3.5-4%. While headline CPI will likely continue to rise, it's not expected to reach the level at which the Bank would feel the need to raise rates. Currently it's seen peaking around 3.2-3.6% later this year or early 2027, which explains the BoE playing the waiting game. Market pricing remains more hawkish – as it does across the entire sovereign debt complex. 

The Bank of England's own Decision Maker Panel survey indicates cooling on the inflation front and limited pass-through from energy. DMP expectations for year-ahead CPI inflation fell to 3.1% in the three months to August, down from 3.4% in the three months to July. Firms' realised annual own-price growth was 3.7% in the three months to August, 0.1 percentage points lower than firms reported in the three months to July.

How does it assess second order impacts?

The big question for the Bank of England is about second order impacts from the energy shock. Governor Andrew Bailey noted recently that the UK had seen “quite subdued second-round effects” alongside a softening labour market. The labour market report last month showed wage growth cooled to 2.8%, the lowest since October 2020. This is not 2022; wages are not about to spiral due to the pent-up demand and dislocation in the labour market as an aftershock from the pandemic. Interest rates are already a lot higher and there is not the same fiscal impulse.

Nevertheless, as noted above, due to the rise in energy prices and the persistence of the shock, we have entered the Bank's 'adverse scenario', potentially calling for 4 hikes. Therefore how the Bank views the context of this adverse scenario is going to be vital. Has the persistent rise in energy prices actually broadened out yet? Not really, so it's likely a case of waiting to see.

I will be looking for language around the persistence of energy-based inflation and whether Governor Andrew Bailey pushes back against market pricing for four hikes through to next year. My belief is that Bailey will push against the hawkish pricing in the markets, as he has been wont to do at times this year. On energy prices, while there are currently not strong indicators that the energy price shock is broadening out, we do know the BoE is focused on how long energy prices stay elevated. Energy price moves are therefore a big factor in assessing the outlook for policy paths, and we will be watching for what Bailey says about this. If oil stays at $100 for the rest of the year then November starts to be in play. On the other hand the lack of passthrough from energy to broader inflation – assumed at adding one whole percentage point to CPI – suggests that this is less important now than thought. Has the Bank changed its assumption on how energy inflation feeds through to the rest of the economy?

Does it see a durable pick-up in economic growth?

Friday's gross domestic product data showed the economy expanded by 0.4% on a monthly basis in July, well above the consensus forecast for no growth. It marks an unexpectedly positive start to the third quarter and comes after official data showed productivity improving as output per job rose 1.4% in the year to June. Both the growth and productivity numbers may be attributed to the AI boom.

The figures may indicate that current policy rates are not too restrictive and could allow the BoE to move rates higher without damaging the economy. We'll see if the BoE thinks this is durable or not.

Can it trust the data?

There have been well documented problems with ONS data. But event the Bank's own reports might be suspect. The BoE has just reported a big drop in consumer inflation expectations after it changed its survey provider.

August data from Savanta reported a fall in year-ahead inflation expectations to 3.2% and ‌3.2% ⁠for five years ahead. Ipsos data for May showed year-ahead inflation expectations of 4.0% and 3.9% for five years ahead. A lot has happened between May and August but the BoE also had Savanta do the May calculations and even then they were about half a percentage point different. 

Thursday's Monetary Policy Committee meeting is expected to see policymakers back waiting a little longer and keep interest rates steady. The BoE will also vote on quantitative tightening – will they choose to end outright sales of gilts to help out the market?

Will it end QT?

Alongside the rate decision the MPC will vote on quantitative tightening (QT) programme. The stock of government bonds held on its balance sheet is down to £490bn from a peak of £875bn, having cut its holdings by £70bn in the 12 months to the start of September. This has included £21bn of active gilt sales, which may be adding to pressure to the long end of the UK gilt curve and widening spreads with peers. No other major central bank has carried out active bond sales to pare back crisis-era balance sheets, and the BoE has faced calls to end the process. It's likely the Bank will trim the pace of QT to £50bn from the current £70bn.

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