Market News

(Bloomberg) --

The Bank of England is likely to keep interest rates in painful territory through this year or longer even as the economy falls into recession.

Inflation is running five times above the BOE’s target, and Governor Andrew Bailey is concerned that worker shortages are feeding wage pressures. The market is betting on another 1 point increase in the benchmark lending rate this year and has walked back bets for a reduction thereafter.

That’s in sharp contrast with the US, where investors anticipate the Federal Reserve to deliver the first cuts in borrowing costs since the start of the pandemic as soon as November.

“The BOE is going to have to keep bearing down on inflation for quite a long time,” said Robert Wood, chief UK economist at Bank of America. He said the UK “stands out” as having the worst of problems in the US and Europe, adding that underlying price pressures and strong pay growth mean “this inflation is going to last.”

The latest economic data reported this week showed wage pressures at record levels, except for the period directly after the pandemic. Inflation ticked down for a second month to 10.5%. Bailey said he hoped a corner has been turned on inflation, but he also noted the scarcity of workers is leading to pay raises that may feed into higher prices.

The result means the quickest monetary tightening cycle in three decades has further to run. Markets have almost fully priced in a half-point increase from the BOE in February to 4%, the highest since 2008, and then another half point by the third quarter. In the US, investors see the Federal Reserve reversing some of its increases in the second half of the year.

For British households, that means more pain. Families are already struggling with the tightest cost-of-living squeeze in a generation and wages falling short of inflation. The central bank has warned that 4 million households will have to remortgage this year at significantly higher rates — adding hundreds of pounds to monthly repayments. 

Those factors solidify forecasts that the economy will struggle to grow before 2024. While the rest of the Group of Seven nations have recovered pre-pandemic levels of output and are planning for growth, albeit sputtering at times, the UK is headed into a long but shallow recession. That’s adding to pressure on Prime Minister Rishi Sunak to come up with a growth plan.

Some strategists believe divisions on the nine-member Monetary Policy Committee could even force the BOE to return with more rate hikes after a pause in its tightening cycle expected later this year.

The majority of the MPC backed a half-point increase last month. But Silvana Tenreyro and Swati Dhingra are pushing for no change while Catherine Mann wanted bigger hikes. Chief Economist Huw Pill has said the UK has the worst features of both the US and European Union economies — a high level of workforce dropouts and an energy supply crisis.

Sanjay Raja, chief UK economist at Deutsche Bank AG, said the UK is in a “unique situation” because of “stubbornly resilient” underlying price pressures and services inflation that is yet to peak.

Britain’s inflation rate is also well above the 6.5% level in the US, adding to concerns that long-term expectations about where prices are headed have come loose from the 2% anchor. Core inflation in the UK that excludes volatile food and energy costs remained stubbornly stable at 6.3%, and price growth accelerated in services.

“We don’t expect any rate cuts this year as inflation will likely stay uncomfortably above the Bank’s 2% mandate,” said Raja. “The BOE will need to keep up pressure on inflation by leaving rates in sufficiently restrictive territory for a little longer.”

The first cut for the BOE’s base rate is not fully priced in by investors until February 2024. The UK’s key lending rate will then remain around 4% until at least the summer 2024, according to money-markets bets.

“At the next meeting I think they will go for 50 (basis points), and then the question is what happens next,” said Guillermo Felices, global investment strategist at PGIM Fixed Income. A downshift in hikes from the Fed could put pressure on others to scale back tightening.

Aaron Rock, investment director at Abrdn Plc, expects the BOE to pause on rate hikes when it reaches 4.25%, but he warned of the risk that the MPC needs to restart its tightening cycle.

“I would not absolutely rule out stickier inflation and a tighter than expected labor market forcing the MPC to return with another 25 basis points hike or two either,” Rock said. He said investors should “not price in deep and rapid rate cuts at the first sight of a moderation in headline inflation.” 

Read more:

• BOE Governor Sees Signs UK Has Turned Corner on Inflation
• BOE Says 4 Million Households Face Higher Mortgages in 2023
• UK Retailers’ Worst Year Ever Caps Grim Outlook for Economy
• UK Inflation Is Falling More Slowly Than in US or Germany: Chart
• UK Wages Rising at Near Record Pace Add to Pressure on Rates

--With assistance from Libby Cherry and Andrew Atkinson.