BoE surprises markets by leaving rates on hold

In a surprise move, the Bank of England (BoE) left the policy rate unchanged at 5.25% at its meeting on 21 September, ending a cycle of 14 consecutive rate hikes. The MPC noted that recent indicators of inflation had been mixed. This justified keeping rates on hold to allow for past monetary policy tightening to fully impact the economy.

Chart 1. UK Inflation decelerating

Source: Bank of England and EFGAM. Data as of 25 September 2023.

The MPC acknowledged that the 8.1% increase in average private sector weekly earnings in the three months to July was 0.8% higher than its August projections. However, this increase did not translate in other measures of UK wage inflation tracked by the BoE and it maintained the expectation that earnings growth will fall to 6% by the end of 2023.

Keeping rates on hold was justified by a recent deterioration in labour market data and a deceleration in economic activity during the last months. In July, the unemployment rate rose from 4.2% to 4.3% and the number of job vacancies fell to less than one million. GDP grew by only 0.2% quarter-on-quarter in Q2-23 and the BoE estimates of growth in the second half of the year have been downgraded.

Headline CPI inflation declined slightly from 6.8% to 6.7% in August. Rising prices of motor fuel made the largest upward contribution to monthly inflation, but this was more than offset by the decline in services prices. Therefore, core inflation, excluding energy, food, alcohol, and tobacco, fell more than expected from 6.9% in July to 6.2% in August.

In the weeks before the MPC meeting, senior BoE officials, including Governor Andrew Bailey, Deputy Governor Ben Broadbent and Chief Economist Huw Pill, questioned the need for further rate increases. One argument supporting this view was that, according to the BoE’s models, the forecast path of inflation over the next three years was almost identical regardless of whether the MPC kept rates unchanged at 5.25% (scenario 1) or if they chose to follow market expectations of rates peaking at 6% in 2023 before falling to 4.5% in 2026 (scenario 2). The summary of the BoE’s inflation forecast under both these scenarios is presented in Chart 2.

Chart 2. BoE headline inflation projections based on two scenarios

Source: Bank of England and EFGAM. Data as of 25 September 2023.

The almost unnoticeable differences between these two scenarios supports the decision of keeping rates on hold and that the recent deterioration in data suggests that further rate hike would risk causing a recession.

In any case, the MPC statement does not rule out future rate hikes in future meetings suggesting that members believe risks to inflation remain tilted to the upside. Moreover, the BoE stressed that monetary policy would need to remain restrictive for a sufficiently long time to return inflation to the 2% target.

Chart 3. Probability distributions for next BoE rate decisions

Source: LSEG Data & Analytics and EFGAM. Data as of 25 September 2023.

To conclude, the dovish tilt from the BoE at its last meeting surprised markets who were expecting another rate hike. Current market expectations see rates on hold until the first half of 2024, with a small probability for further rate hikes in a scenario of persistent inflation (see Chart 3). Overall, the BoE will focus on indicators of services price inflation, labour market strength and wage growth, all of which should slow if economic activity deteriorates in the remainder of 2023. For the time being, future BoE’s decision will be data dependent, not ruling out further policy tightening if required.