When the Bank of England’s Monetary Policy Committee (MPC) raised policy rates from 3.5% to 4.0% on 2 February the market immediately priced-in an expected year-end rate of 3.9%. This implied a small chance of a rate cut in 2023. Four weeks on and the market is pricing in a policy rate of 4.75% by the year-end, a huge turnaround in expectations. How did this happen?
Firstly, why did we get as low as 3.9% initially, after the meeting in early February? The simple answer is that the MPC changed its guidance; they moderated previous language suggesting they were considering ‘forceful’ hikes, in favour of saying that: “if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.”
So what did the MPC mean by ‘persistent pressures’? They appear to be referring to wages and services inflation, with the new messaging indicating that they would only act if the figures were worse than expected, and that they would likely respond by raising rates by 25 bps rather than an increment of 50 bps. The market saw this as a clear signal that the Bank would not need to raise rates unless the inflation data came in worse than expected. So how has the data been in the interim?
Well, we have had both employment data and inflation data out of the UK and both have been mixed, in some cases lower than expectations. The Bank of England’s Chief Economist, Huw Pill, referenced that the labour market has recently loosened a little in terms of vacancies and unemployment, but noted that pay growth was revised higher than expected at 7.3%. On inflation, it fell faster than expected, from 10.5% to 10.1%. It would be difficult, therefore, to attribute the change in market pricing rates to the domestic economic data being stronger than expected.
It appears that the UK market is reacting to overseas developments. There has been a big move in interest rates in the US over the past month, with Fed Funds expectations moving sharply higher. End-of-year pricing has gone from 4.35% to 5.30% over the same period, reflective of what has been unambiguously stronger US data. The labour market in the US appears to be tighter, economic activity is coming in higher, and there is no denying that we have seen higher revisions to inflation data.
However, it is worth remembering that we have only really seen one month of stronger data to buck the trend of slowing inflation data that we had seen over recent months. Not only do we question the extent of the US market reaction to a relatively small data sample, we also wonder if the gilt market reaction has been entirely rational.
The Bank of England will get one more round of data on the labour market and inflation before the next MPC meeting on 23 March. If we see a continuation of the trend to lower inflation, and an ongoing loosening of the labour market – and if the Bank continues to believe that consumer price inflation will be below target from 2024 – it would not be a surprise to see a moderation in domestic interest rate expectations away from what we believe is too high a level (4.75%), and a repricing lower.
If our assessment of the Bank’s approach is proven to be correct, then this would be supportive for the gilt market after what has been a difficult February.
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