Hawkish BoE spurs markets to revise rate expectations

The Bank of England has issued its strongest guidance in a decade that it is poised to raise interest rates, setting the stage for a nail-biting decision at the November meeting of the Monetary Policy Committee.

Voting seven to two against an immediate increase in rates at the central bank’s September meeting, a majority of MPC members signalled that unless there is a sudden string of bad economic data, “some withdrawal of monetary stimulus is likely to be appropriate over the coming months”.

This guidance on rates is unusual from the BoE and suggests the committee is seeking to test financial markets’ likely response to a quarter point rate rise from the current low of 0.25 per cent at the November meeting.

It also puts the BoE on the same course as two of the world’s other major central banks, the US Federal Reserve and the European Central Bank, for a simultaneous tightening of crisis-era easy money policies before the end of the year.

The US labour department released inflation data that were unexpectedly strong in August, after five straight months of undershooting economists’ expectations, making it more likely the Fed will raise rates in December.

With the European Central Bank signalling that it would decide in October how to phase out its €60bn-per-month stimulus, yesterday’s announcements set the stage for a fourth quarter where all three banks could move to normalise policy after months — in some cases years — of inaction.

Investors responded to the BoE’s words by revising sharply their views on the timing of an interest rate rise. Pricing in the overnight index swap market, which shadows official interest rates, now predicts rates are likely to rise by the end of this year rather than late 2018, which the same market was predicting a week ago.

Sterling rose 1.2 per cent to $1.34, its highest level in 12 months, and it strengthened by the same proportion against the single currency so that one euro cost 88.7 pence.

UK government bond prices fell, pushing the 10-year gilt yield up six basis points, while the stronger pound hit shares of those UK blue-chips with significant foreign currency earnings, leaving the FTSE 100 down 1 per cent.

Most economists rushed to change their expectations of interest rate rises in the wake of the BoE’s words. Lee Hardman, currency analyst at MUFG, said: “The Bank of England has delivered a significant hawkish policy surprise today by signalling that it is likely to begin raising rates as soon as at their next policy meeting in November.”

George Buckley, of Nomura, said: “One can read into these minutes the clear preparation of ground for an imminent interest rate rise”. But some still thought the BoE wanted to change market perception rather than pull the trigger.

Economists and financial markets had expected some hawkish noises from the BoE because its suggestions in August that interest rates were likely to rise faster than the markets and businesses expected, fell on deaf ears. But the new assessment that a rate rise was likely to be needed in the next few months was much stronger than expected.

The minutes of this week’s meeting repeated the August statement that all MPC members thought interest rates would need to be increased more quickly than current market expectations.

In addition, a new paragraph in the minutes noted: “A majority of MPC members judge that, if the economy continues to follow a path consistent with the prospect of a continued erosion of slack and a gradual rise in underlying inflationary pressure then, with the further lessening in the trade-off that this would imply, some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.”

In its assessment of the economy, the MPC judged that the economic news pointed “if anything to a slightly stronger picture than anticipated”, indicating that a majority on the MPC thinks that the data have cleared the bar for a rate rise in the near future.

The MPC noted that inflation was likely to rise above 3 per cent in October and, with unemployment at a 40-year low of 4.3 per cent, the room for further non-inflationary growth was limited. It said pay growth, the Achilles heel of the UK economy, “has shown some signs of recovery, albeit remaining modest”.

The MPC’s mandate requires the committee to seek to hit a target of 2 per cent inflation and it judges that inflation is likely to exceed that target during the next three years.

The committee also warned that weak growth and squeezed household incomes were no bar to tighter monetary policy because Brexit was likely to require a painful adjustment. “Monetary policy cannot prevent either the necessary real adjustment as the UK moves towards its new international trading arrangements or the weaker real income growth that is likely to accompany that adjustment over the next few years,” the BoE said.

Two MPC members, Michael Saunders and Ian McCafferty, voted for an immediate rise in interest rates to 0.5 per cent, saying that rates at this level would still be “very supportive”. But the majority, including new member Dave Ramsden, the deputy governor for markets and banking, thought it “too soon” to raise rates immediately and the committee “could undertake a full assessment of recent developments and the data released over the next couple of months, in the context of its November forecast round”.