The central bank decides risks of higher inflation outweigh risks of disruption related to Covid-19 variant.
The Bank of England (BoE) has once again surprised financial markets, though this time by raising the policy interest rate from 0.1% to 0.25%.
As a result, sterling has risen 0.6% against the US dollar, and 0.25% against the euro. The FTSE 100 has fallen back compared to just before the announcement, but remains up on the day, and the benchmark 10-year gilt yield has risen (price fallen).
The BoE disappointed investors in November when it hesitated to hike. On this occasion, the consensus had backed away from the notion of tightening due to the spread of, and uncertainty caused by, the new Omicron variant of Covid-19.
Our last update highlighted the strength of the labour market and the lack of job losses caused by the end of the government-backed furlough scheme. Average hours worked have almost recovered to pre-pandemic levels. With the number of unfilled job vacancies continuing to rise, data suggests that job-to-job flows have hit a record high.
All of these observations point to a very tight labour market, which has been exacerbated by post-Brexit migration rules.
Meanwhile, inflation has risen to 5.1% in November, largely due to higher wholesale energy prices, but also due to bottlenecks in goods production more broadly. Even services companies appear to have been emboldened to pass rising costs on to their consumers.
Our forecast has UK CPI (consumer price index) inflation rising to above 6.5% by April 2022, with risks firmly tilted to the upside. Although the RPI (retail price index) measure of inflation has lost its prominence, it is still watched, and could hit double digits next year.
Higher inflation, even if driven by temporary factors, could easily trigger higher wage inflation due to labour shortages. This would then push up costs and prices further, and could start a wage-inflation spiral.
Ultimately, the BoE has decided that the risks of disruption from the Omicron variant are outweighed by the risks of higher medium-term inflation. It is worth remembering that the rate increase is small at just 0.15 percentage points.
Additionally, interest rates are still incredibly low given the UK’s current and projected growth rates and inflation. We expect the BoE to follow up with another rate rise in February, taking the policy rate to 0.50%.
However, the Bank is then likely to pause as inflation should trend downwards from the second quarter onwards. It could potentially bottom out below 1% - the lower bound of the BoE’s inflation target range.
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