Janus Henderson: Hawkish BoE at odds with market?

The MPC unanimously decided to raise the Bank Rate to 0.75% from 0.50% as expected, while retaining the commitment to keep further increases gradual and limited.

After a disappointing start to the year when the bank kept rates on hold as it waited for better economic data, Q2 has shown signs of an improving landscape. Q1 gross domestic product (GDP) figures were revised upwards and Q2 preliminary estimates are around 0.4%. While some of the pick-up in Q2 can be attributed to transitory factors such as good weather, the royal wedding and the world cup, it is hard to dismiss the improvement in GDP against the backdrop of an economy close to full employment with inflation above the target of 2%.

The BoE Agents’ survey* update shows recruitment and retention difficulties have increased and indicators of pay growth have firmed, for both the private and public sectors, over the past year. The bank continues to expect a gradual pace of hikes — one per year — to be sufficient to keep inflation at target.

First estimate for r*

The Inflation Report also brought the BoE’s first estimate for equilibrium long-term neutral rates (r* — the level of rates which proves neither expansionary nor contractionary). 

The bank’s forecast of 2-3% (in nominal terms) surprised to the upside versus market expectations of 2-2.5%. While this is slightly hawkish and would normally imply a more aggressive hiking cycle, considering the MPC expects full employment in 2020, at which point policy rates should be at neutral, shorter term headwinds and ambiguity surrounding Brexit still weigh on the economy. This means that the neutral interest rate will be below the long-term forecast until uncertainties diminish. 

Markets lack faith about the number of future hikes 

Market reaction has been fairly muted post the meeting; with no change in the expected timing of the next hike, which is priced for November 2019. With poor monetary growth data and core inflation, as well as the prospect of a very uncertain second half of the year, the market continues to lack faith in the number of hikes the BoE will be able to deliver.

August was also the last meeting for MPC member Ian McCafferty, who has been the most hawkish in recent years. He will be replaced by Jonathan Haskel, who appears to be more aligned with the current MPC majority, leading to a modest dovish tilt in the MPC’s composition.

*Agents’ summary of business conditions