The Bank of England is set to raise its benchmark interest rate to 4.75% on Thursday in response to an inflation problem that has become more difficult and persistent over the past month.
The expected 25 basis points would mark the 13th consecutive rise in borrowing costs since the central bank’s Monetary Policy Committee began pushing rates higher in December 2021.
UK inflation was 8.7% in April, higher than most comparable economies and well above the Bank of England’s 2% target. Financial markets are increasingly convinced that interest rates will only fall if they rise sharply, hitting mortgage borrowers in a way not seen since the early 1990s.
It means Britain’s long-running cost of living crunch is now accompanied by a mortgage “time bomb”, with hundreds of thousands of households facing rising costs as the deadlocked deal ends with a general election expected in 2024.
Economic conditions put further pressure on Rishi Sunak and his government when two-year fixed mortgage rates hit 6 per cent on Monday.
Bank of England Governor Andrew Bailey is also in the spotlight for the central bank’s performance in keeping inflation under control. In the past six weeks, he has been forced to admit that the bank underestimates short-term inflation and that its forecasting models are not functioning properly.
He also acknowledged that the bank had “lessons learned” in the conduct of monetary policy and had ordered a fast-track review of its forecasts and communications.
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With that in mind, traders and economists will listen to the central bank’s comments on Thursday while scrutinizing its actions and will be looking for clues on how much rates will rise.
One of the most important factors in how the bank communicates its decision will be Wednesday’s May inflation figures.
Economists expect headline CPI inflation to ease to 8.5% from 8.7% in April, driven by price cuts, especially for diesel. But core inflation is expected to hold at 6.8%, well above the central bank’s 2% target.
Strong inflation and wage data over the past month have changed the outlook for interest rates in the eyes of financial markets.
Although official data last month showed that the CPI inflation rate fell from 10.1% in March to 8.7% in April, it was still much higher than the Bank of England’s internal expectations, showing that underlying inflationary pressures far exceeded expectations. Over the same period, core inflation excluding food, energy and alcoholic beverages rose to 6.8% from 6.2%.
Last week’s wages data added to the sense that the Bank of England failed to understand price setting, with average earnings rising at a near-record annual rate of 7.2% between February and April. This suggests that there is almost certainly a stronger ratchet effect between wages and prices in the UK than in other countries.
Traders betting on the future of the Bank of England’s benchmark interest rate now expect it to peak at 5.75% by the end of the year, a full percentage point higher than they had expected at the Monetary Policy Committee’s last meeting on May 11.
Economists also sharply raised their rate forecasts and were more confident than usual that the Monetary Policy Committee will raise rates on Thursday, amid dismal data and market moves over the past month.
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“All the indicators of ongoing inflation pressures that the BoE has said it will be watching have turned up unexpectedly, or are in line with the BoE’s forecasts,” said Robert Wood, UK economist at Bank of America.
Samuel Tombs, chief UK economist at Pantheon Macroeconomics, said April wages and price data left the BoE with little choice but to act. “The Monetary Policy Committee’s 0.25 percentage point hike in the bank rate to 4.75% on Thursday is almost a foregone conclusion,” he added.
Economists, politicians and mortgage borrowers will also want to know on Thursday how far the central bank thinks it needs to go if a rate hike is widely expected.
Normally, the Bank of England does not hold a press conference after its June meeting. However, the market has been so volatile over the past month that they may force Bailey to comment.
If the MPC thinks financial markets are making borrowing too expensive, he could push back against expectations of further rate hikes, as he did in November, when he said he expected rates to rise “less than what financial markets are currently pricing in.”
However, this could make banks appear too complacent about inflation and damage their credibility.
By contrast, if the central bank doesn’t say much, the lack of guidance could mean that mortgage rates will remain high, causing unnecessary financial pain for many households and governments, and potentially pushing the economy into recession.
BoE watchers believe the MPC is unlikely to comment on Thursday and will retain its current guidance that it will raise rates further if there is evidence of persistent inflation.
Bruna Skarica, UK economist at Morgan Stanley, said she did not “expect a strong resistance to market pricing”, although in her view BoE officials did not see the need for rates to rise by more than 5%.