Bank of England June preview: MPC to hold rates steady even as CPI inflation rises again

The Bank of England is set to leave interest rates on hold on Thursday but the divergence between hawks and doves could become more pronounced as worries over inflation are reflected in another split vote and a jump in CPI the day before the decision.

Despite expected higher inflation numbers, which are due out Wednesday, increasingly I think the hawks are looking like they’re out an a limb; I expect markets to rightly reprice for the Bank not to hike this year. I have consistently said the next move for the Bank is a cut – not something the gilt futures curve is currently priced for, albeit the 2yr gilt yield has declined about 40bps since the last BoE meeting. Markets now see just a 25% chance of a hike next month and are priced for just one 25bps increase this year, down from 3 hikes priced at the peak. Still, the bias is towards tightening and I think this is misplaced.

CPI inflation for May is seen rising to at least 3.0% from the 2.8% recorded in April. But with the US-Iran peace deal looking positive for energy markets (ie lower prices), there will be no appetite among the majority of rate-setters to hike. Lower gas futures prices in particular indicate that CPI won’t breach the 4% level that is particularly sensitive for the BoE – last year it indicated that CPI north of 4% was when it became more entrenched. We are not at this level and I don’t think we will get there – this is not 2022.

Governor Andrew Bailey will lead a majority vote in favour of leaving rates on hold at 3.75%. In my view a majority within the nine-strong Monetary Policy Committee made it pretty clear at the last meeting that they were prepared to look through a temporary rise in inflation due to the spike in energy costs from the Iran war. This week’s peace deal and subsequent drop in crude oil prices would tend to suggest they were right to do so, though of course the data remains the key.

At least a couple of rate-setters, led by chief economist Huw Pill and external member Megan Greene, think the Bank should act proactively to contain second order inflation effects. The usually hawkish Catherine Mann may join them, but I think on balance given the peace deal she would prefer to wait until July before making a call. Repeat this is not 2022.

The meeting comes after the European Central Bank and Bank of Japan both hiked rates. Meanwhile bets are increasing for the Federal Reserve to hike this year. But I do not believe the UK is in the same position as peers and needs to avoid prematurely raising rates. That's why I expect this week to be critical for FX markets and cable in particular as monetary policy divergences will start to be reflected in market pricing.

Reasons not to hike are piling up. 

1. The US-Iran peace deal this week has considerably eased concerns about energy prices, with crude futures declining to early March lows and gas futures materially below their highs. While it will take time to shake out, this materially reduces the tail risk that higher inflation becomes entrenched, and inflation expectations become de-anchored.

2. April GDP data showed the UK economy contracted.

3. Labour market contraction – job openings in three months to April fell to 705k, the lowest since 2021. Unemployment ticked up to 5% from 4.9% and payrolls fell by 100k, the steepest decline since the pandemic onset in May 2020. In short the balance of risks as we stand is weighted towards falling employment not higher inflation.

4. Wage growth is cooling to sub-3% - this is not 2022

5. Inflation fell to 2.8% in April, albeit it’s seen ticking up a bit more. However the decline crude and natural gas futures for next winter to pre-war levels indicate that we will get a significant cooling after the summer.

6. And the Bank of England’s last Decision Maker Panel survey didn’t suggest much pass-through of price hikes and concerns about second order inflation impulses. One-year ahead CPI expectations fell in May from the month before, employment is negative and wage growth isn’t picking up. Notably, 57% of firms think prices will be higher because of energy, 68% expect their profit margins to fall. Cue MPC dove Alan Taylor: “I think interest rates don’t need to go higher as they’re quite restrictive at the moment.” 

7. And finally, politics is likely to be the cause of a lot of tension in gilt markets and be the source of bigger surprises with the Makerfield by-election – which conveniently is also on Thursday. Andy Burnham will launch an immediate challenge to Keir Starmer and we could have Ed Miliband as Chancellor within weeks...that’s the major risk for gilts now. No reason to hike into this kind of environment.

Risks to this dovish scenario: Really, it’s only about where inflation gets to. Certainly inflation could spike once more and risk becoming more entrenched if the Iran deal breaks down – and there are plenty of reasons why this could happen – or, even if the Strait of Hormuz reopens fairly swiftly (a best case) commodity prices may rise again and threaten to push CPI towards 4%, which would get the attention of rate-setters in the middle of the MPC to lean hawkish. These are not immaterial risks, just not what I’d consider my base case. The biggest risk may be that restocking of inventories combined with a slower-than-expected (at least in terms of what Brent futures indicate today) resumption of flows pushes up prices of barrels further out the curve. Note that the curve has moved from extreme backwardation to something a lot a lot flatter. Lots more on this here from Ole.
And for market pricing - the question is whether there is any indication about July. Without a new economic forecast or press conference, the focus on that front will probably rest on how many - if any - of the 9 MPC members join Huw Pill and Megan Greene. I expect a 7-2 vote. If Catherine Mann does call for a hike it would be a hawkish read all else being equal.

For sterling – I expect that the market reprices on two fronts – a more dovish Bank of England and a more hawkish Fed. This would tend to be sterling-negative. Coupled with political risks GBPUSD could retreat to 1.30. The cross currently sits in a tight consolidation mode around the 1.34 handle where the 20-day and 200-day moving averages have converged. Cable has gained some ground on USD haven flows reversing. The bullish crossover on the MACD may indicate near-term momentum to the upside but markets are yet to reflect the mon pol divergence I expect to materialise this week.