Bank of England set for first interest rate hike in over ten years

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The Bank of England looks on course to raise interest rates in the UK for the first time since July 2007 this week, a little over a year after rates were slashed to a record low 0.25% in the immediate aftermath of Britain’s EU referendum.

Bank of England Governor Mark Carney claimed in August 2016 that the central bank would take ‘whatever action is needed’ to prevent a recession in the UK following the Brexit vote. While the UK economy has slowed this year, we’ve so far seen no evidence that a recession is imminent and the market is now overwhelmingly expecting policymakers to vote in favour of an immediate increase in rates from their current historic low level on Thursday.

The Bank of England prepared the market for an interest rate hike at its latest meeting in September, shifting to a markedly more hawkish tone. There were no surprises in the vote among policymakers with hawks Ian McCafferty and Michael Saunders remaining the two sole dissenters on the committee in favour of an immediate hike. A ‘majority’ of members judged that some removal of stimulus would be appropriate should they see a ‘gradual rise in underlying inflationary pressure’. The MPC also noted a stronger economy since the last set of economic forecasts in August, citing signs of a firmer housing market and an improved labour market situation.

Since the September meeting, a number of MPC members have also talked up the possibility of an increase in its main rate. Gertjan Vlieghe, who was deemed by many as one of the most dovish members on the rate setting committee, warned in September that it was ‘approaching the moment when [the] Bank Rate may need to rise’. New MPC member Silvana Tenreyro claimed in October that she may back a rate hike ‘in the coming months’ if inflationary pressures build in the labour market. Carney himself has also said that the UK economy was nearing a ‘tipping point at which it would be necessary or justified to remove some stimulus’.

This rather dramatic hawkish shift suggests that the majority among the committee may be tilting towards tightening at this week’s meeting. We are pencilling in a 6-3 majority vote in favour of higher rates this week with the more dovish Jon Cunliffe, Sir David Ramsden and Tenreyro (Figure 1) the only members of the committee to vote in favour of no change.

Figure 1: Bank of England Hawk/Dove Scale

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The need for higher rates has come off the back of a sharp increase in the rate of UK inflation. Consumer price growth has accelerated at a rapid pace since falling into negative territory in late-2015, particularly following the Brexit induced depreciation in Sterling last summer. Headline inflation rose to a five year high 3% in September, while a core measure of 2.7% is also around its highest level since early 2012 (Figure 2). This is now comfortably above the Bank of England’s strict 2% target and Governor Carney has recently warned that prices are likely to increase further before the end of the year.

Figure 2: UK Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 30/10/2017

We also had the news last week that economic growth had unexpected accelerated in the third quarter. The UK economy grew by 0.4% in the three months to September compared to 0.3% in the second quarter, its highest level since the end of 2016. While still relatively low compared to most other G20 countries, this is far from the doom and gloom levels that many economists had anticipated prior to last year’s referendum.

We were among the very small minority of analysts that had called for a Bank of England interest rate hike earlier in the year. Following the September BoE meeting and recent jump in UK inflation, financial markets are now pricing in a near 90% chance of a rate increase at this week’s meeting (Figure 3). This is a significant departure from the less than 10% priced in earlier in the summer.

Figure 3: Bank of England Rate Hike Probability [November] (Jan ’17 - Oct ’17)

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Source: Thomson Reuters Datastream Date: 30/10/2017

With an interest rate hike now fully priced in, Sterling is expected to take its cue from the rhetoric in the statement, the projections in the quarterly Inflation Report and Carney’s accompanying press conference. We think that Carney will be reluctant to vocalise the need for a one-and-done hike and instead prepare the market for a very gradual hiking cycle. Carney is likely to reiterate that medium term inflationary pressures remain elevated and we expect language that would point to a gradual path of hikes over the coming years.

The market is currently pricing in one additional hike in 2018, which remains slightly on the conservative side. We therefore think that the hint of additional interest rate hikes next year could provide solid support for Sterling this week and support our view for a gradual appreciation of the Pound in the coming months, particularly against the Euro. Contrastingly, the lack of a hike at Thursday’s meeting would be a significant disappointment and we’d expect to see a sharp sell-off in the Pound against every major currency.

 

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