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Bank of England considers biggest rate rise for more than 25 years

Bank of England policymakers will be under pressure to accelerate the pace of monetary tightening when they meet this week, following the example of the European Central Bank and the US Federal Reserve.

Andrew Bailey, the BoE governor, has made it clear that while a 0.5 percentage point rate hike is “not stuck,” it will be “one of the choices on the table” when the monetary policy committee makes its policy decision on Thursday. . The BoE has been raising interest rates in 0.25 percentage point increments since December, but pledged in June to act “forcefully” if necessary in response to more ongoing inflationary pressures.

However, if the MPC follows suit and the central bank’s benchmark rate rises to 1.75 percent, it will be the steepest rise in borrowing costs in more than a quarter of a century.

Analysts say the decision will be well-balanced as policymakers weigh relentless inflationary pressures against the mounting risks of a recession. But a growing number of forecasters believe opinion on the MPC will swing in favor of the first 50 basis point increase since independence.

“After the ECB and Fed make excessive hikes at their July meetings, the Bank of England is likely to feel the same pressure,” said Amarjot Sidhu, economist at BNP Paribas, while Investec’s Philip Shaw said the BoE “may fear a credibility problem if it is seen as lagging behind its peers”.

Line chart of forward interest rates in the Overnight Index Swap Market (%) showing that markets expect interest rates to peak close to three percent

The IMF, which lowered its global growth forecasts this week, pointed to the UK as one of the countries where the inflation outlook had deteriorated the most. It urged policymakers to take “decisive action” even if it affected growth, jobs and wages in the short term — arguing that a gradual approach would simply lead to a more disruptive adjustment later on.

“If the BoE continues to gain 25 basis points per meeting, it would be outperformed by most other central banks,” said Fabrice Montagné, an economist at Barclays, adding that the pound’s 3% depreciation since April has reflected the perception of the markets “that the UK is lagging behind”.

Inflation, which reached 9.4 percent in June on the basis of the BoE’s targeted CPI measure, has so far risen broadly in line with the central bank’s May forecast. But the latest rise in gas prices means that the BoE is likely to rise even further into double digits than expected in the fall, when the cap on regulated energy prices will rise again, according to new forecasts.

The MPC can do nothing about the high energy prices, but it will be concerned about the knock-on and potentially lasting effects on corporate and household behavior – which it can influence.

Line chart of UK GDP (February 2020 = 100) showing that growth has held up better than the BoE expected

Meanwhile, recent data indicates that economic growth has held up better than the BoE expected in the second quarter of 2022. At the same time, employment continued to grow strongly, amid ongoing labor shortages that have supported rapid nominal wage growth.

Policymakers said in June that the “scale, pace and timing” of any further rate hikes would reflect their assessment of the economic outlook – and that they would be “particularly alert” to signs of more lingering inflationary pressures.

“The MPC faces the prospect of higher and more persistent inflation and an economy that is slowing but not crashing. So another rate hike seems inevitable,” said Andrew Goodwin of the Oxford Economics consultancy. He is one of the economists who still think the BoE will stick to a more conventional 0.25 percent hike, but acknowledged that it could easily justify a bigger move.

Policymakers may also worry that the tax cuts made by Liz Truss, the frontrunner in the Tory leadership race, will lead to a fiscal splurge later in the year — forcing them to raise rates further — though the BoE will only do so in its forecasts once government policy had become.

In addition to its decision on interest rates, the BoE will also provide more details about its plans to start selling some of its gold holdings, possibly preparing to vote in September and begin selling the following month. However, Bailey has indicated that the BoE wants interest rates to remain the main tool for tightening monetary policy, against the backdrop of a steady QE run-down.

The big question for investors, however, is whether a bigger move by the BoE would be a one-time move, or the start of an aggressive tightening cycle.

At the moment, traders are betting that interest rates will peak close to 3 percent in early 2023, meaning there will be at least two more 0.5 percentage point hikes by the end of this year.

Most analysts believe this is going too far, as the BoE has repeatedly signaled that medium-term inflation would fall below the 2 percent target if interest rates rose in line with market prices.

“Recession risks are clearly increasing and that is the most obvious reason for the Bank to stop tightening by the autumn. . . by the fourth quarter, we will probably see the full impact of the cost of living,” said James Smith, an economist at ING, adding that while the increase in energy and food prices has been “eye-watering”, broader inflationary pressures have already begun to abate. cooling.

Paul Dales, of the consulting firm Capital Economics, is one of the few forecasters to share market expectations that yields will hit 3%, but he also said that despite more aggressive measures from other central banks, a 50 basis point increase “might be the top speed.” of the MPC”.

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