Conundrum deepens as inflation, labor market stay hot

LONDON – The Bank of England is “between a rock and a hard place” as it prepares for a key monetary policy decision against a backdrop of stubbornly high inflation and a tight labor market, economists said.

Consumer price index data for May will be released on Wednesday morning, a day before the central bank’s Monetary Policy Committee (MPC) will announce its next move on interest rates.

Data since the last meeting point to persistently tight labor markets, strong underlying inflationary pressures and mixed but surprisingly resilient growth momentum.

As a result, economists now expect the central bank to extend its tightening cycle and raise interest rates higher than previously expected.

UK 2-Year Government Bond Yield The rate rose to a 15-year high of 5% on Monday, before another 25 basis point hike was expected on Thursday.

The central bank has embarked on a series of rate hikes since November 2021, raising the benchmark rate from 0.1% to 4.5%, with current market pricing suggesting it could eventually peak at 5.75%.

Headline CPI inflation was 8.7% in April, down from 10.1% in March, but core CPI, which excludes volatile energy, food, alcohol and tobacco prices, rose 6.8% from 6.2% the previous month.

The Organization for Economic Co-operation and Development forecast earlier this month that annual headline inflation in Britain would hit 6.9% this year, the highest of any advanced economy.

To the collective headache of policymakers, last week’s labor market data was much stronger than expected. The unemployment rate fell more than expected to 3.8%, while the vacancy rate also fell by 0.4 percentage points.

Regular pay, excluding bonuses, rose 7.2% in the three months to the end of April compared with the previous year, also beating consensus estimates. Regular pay in the private sector, the bank’s key metric, rose 7.6% year-on-year.

In terms of economic activity, the PMI in May was slightly lower than market expectations, but remained in expansionary territory, and UK GDP unexpectedly contracted by 0.3% mom in March, before rebounding partially in April, growing by 0.2%.

Terminal interest rate forecast raised

In a research note on Thursday, Goldman Sachs chief European economist Sven Jari Stehn said the BoE sees a need for a 50 basis point rate hike, although some uncertainty remains over Wednesday’s CPI “High barrier” points.

Stehn emphasized that “inflation expectations remain stable, with recent comments suggesting no appetite for a faster pace, and there will be no press conference or new forecasts at the meeting.”

“We expect the MPC to maintain its modal assessment that underlying inflation pressures will cool as headline inflation declines, but acknowledge firmer recent data and note that risks to the inflation outlook remain significant to the upside. We also expect the MPC to will keep its loose forward guidance unchanged,” Stehn added.

Goldman Sachs expects the MPC to maintain a relatively dovish stance given resilient growth, wage pressures and high core inflation, and will continue to be forced to hike rates by 25 basis points on stronger-than-expected data, culminating in a final rate risk of 5.25% Upside.

Economists at BNP Paribas also expect a 25 basis point hike on Thursday, as inflation expectations remain below where they were when the bank raised rates by 50 basis points last year.

The French bank also raised its final interest rate forecast to 5.5% in a note last week, from 5% previously, in response to “clear signs of persistence in inflation”.

Although the tightening cycle is expected to be longer than the upward cycle in order to contain inflation, BNP Paribas said the monetary policy committee would be “vigilant to over-tightening” and would consider weighing the impact on households of rate hikes so far, especially for fixed-rate mortgages Loan renewals will continue into the second and third quarters.

UK mortgage borrowers are being pushed to the brink as rising borrowing costs affect deal renewals and products are pulled from the market.

Laith Khalaf, head of investment analysis at AJ Bell, said the monetary policy committee was “in a dilemma” as it chose between pushing more mortgage borrowers over the edge of a cliff or allowing inflation to run rampant.

“Current interest rate pricing reflects alarm bells ringing in markets, but some easing of inflationary pressures over the summer would add balm to the situation. The Bank of England would also recognize that the full force of its tightening policy to date is still playing out across the economy ,” Khalaf said.

“Having said that, if the inflation data remains poor, the Bank of England will be under pressure to act, as will the Treasury if the Prime Minister’s pledge to halve inflation looks likely to fall short.”