One month ago, Bank of England Governor Andrew Bailey told us that markets were getting ahead of themselves in pricing in rate hikes. This appears to be the key message from the April decision, which keeps interest rates at 3.75%. But it is also clear that the bank is close to raising interest rates in June. This is our base case now.
Like everyone else, the bank deals with uncertainty through scenarios. The middle scenario (b) depends largely on current market prices. The price of oil quickly fell below $100 per barrel, and natural gas remained at roughly its current level for most of this year before gradually declining. Importantly, this scenario does not generate any second-round effects on inflation, as the bank believes. The effect on wage growth is marginal.
In this scenario, most officials still appear to be moving toward keeping interest rates unchanged this year — even if model-based simulations, including the policy report, suggest one, and perhaps two, hikes even as energy prices fall rapidly. Governor Bailey described the decision not to cut, which the Bank was likely to do before the war, as in effect a decision to tighten policy.
The problem here is that the crisis in the Middle East shows little sign of resolution. The chances that we will end up in a less benign scenario are increasing.
There is no doubt that the most extreme scenario facing the World Bank is indeed extreme. It assumes natural gas prices will double, which seems unlikely at the moment. Remember, natural gas prices matter more to UK inflation – and the risk of second-round effects – than oil.
However, our base scenario is a bit more aggressive on energy prices than the Bank’s middle scenario – and with every day that passes without the Strait of Hormuz reopening, the more likely it is that energy prices will remain high for longer. Our forecast for UK inflation, which will peak at just over 4% this year, is higher than in the Bank’s average scenario.
That’s why, after today’s decision, we are now heading towards a rate hike in June. It’s certainly not guaranteed, but that is narrowly our base case now, having previously felt that interest rates would remain on hold through this year.
Whether that is followed by one or even two additional rises, depending on how the markets are currently pricing, we are less convinced at the moment. Clearly, the majority of panel members remain skeptical about this turning into a sustained bout of inflation, similar to what we saw in 2022. We strongly agree with that. Overall, we believe that a rate hike in June may be a reality.
Source: J
