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Former BOE Hawks Say UK Interest Rates Headed to 6% Pain Level - BLOOMBERG

MAY 27, 2023

(Bloomberg) -- Hawkish former Bank of England rate-setters warned that interest rates will need to soar as high as 6% to stamp out inflation, a level the central bank has identified as painful for households and businesses.

Willem Buiter, Andrew Sentance and DeAnne Julius, each of whom previously served on the BOE’s Monetary Policy Committee, and have for months voiced alarm about rising prices, said the UK central bank will need to press ahead with more hikes through the summer. 

“They’re going to have to go significantly higher,” Buiter said in an interview, anticipating a peak of “no less than 6%” and that, “there’s no way in which a 4.5% policy rate will do the job.” 

The comments follow a surprise increase in the core measure of inflation — which strips out volatile energy and food prices — to the highest level in more than 30 years. Investors rushed to price in another 1-point rise in the BOE’s base rate to 5.5%, a level not seen since early 2008 before the global financial crisis hit. 

BOE Deputy Governor Jon Cunliffe in July identified 5% as the level where mortgage borrowers and companies run into debt distress. At the time, the key rate was 1.25%, and markets were pricing in a peak around 3%. 

The UK economy would likely fall into recession in the second half of this year if the sudden shift in market expectations sustains itself through the summer, Bloomberg Economics forecast on Friday. That outlook is much dimmer than the ones published this month from the Bank of England and International Monetary Fund erasing the risk of a serious downturn this year.

The financial impact of higher rates on households could be softened by still-low unemployment and a delayed impact on those with fixed rate mortgages. The UK also is starting to benefit from a plunge in energy prices, which touched off the current bout of inflation when they soared to records last year. 

What Bloomberg Economics Says ...

“Using SHOK, our in-house model of the UK economy, we find that if the rise in risk-free rates (proxied by the five-year swap rate) lingers through the summer, the economy would likely fall into recession in the second half of 2023, with a peak-to-trough fall in GDP of about 1%. That would take our 2023 forecast down from a 0.2% gain to a 0.4% contraction.”

—Dan Hanson, Bloomberg Economics. Click for the INSIGHT.

Former BOE rate-setters with more hawkish views have been vindicated by the stickier inflation.

Julius had a more dovish role on the MPC during the late 1990s and early 2000s but has been warning of the need for a tough stance on inflation. She said Bank rate will need to hit between 5-6%.

“The second round effects are definitely embedded in the economy and I think that’s why it’s going to take longer than been expected to bring inflation down,” she said in an interview.

Sentance, who was on the MPC during the financial crisis and has been more vocal than many in backing higher rates, said a peak of 5.5% is not “unrealistic” but added it would not make sense for the BOE to move in big steps.

“The MPC needs to feel its way, but while inflation is slow coming down, and these indicators of underlying inflation remain high,” Sentance said in an interview. “It needs to continue to edge them upwards.”

UK Chancellor of the Exchequer Jeremy Hunt said on Friday he is comfortable with the BOE causing a recession by raising interest rates more to tackle inflation. A slump in the second half of the year would complicate Prime Minister Rishi Sunak’s bid to stay in office after the next election, which is widely expected in the middle of 2024.

Economists also rushed to boost rate forecasts, signaling the BOE will be forced to push back the prospect of pausing its most aggressive hiking cycle for four decades. HSBC Bank Plc, Barclays, Nomura, Credit Suisse, Bank of America and Capital Economics all raised their rate calls this week. 

However, Ian McCafferty, another hawkish former BOE member, was more cautious. He pointed out that the lags in when rate rises bite into the economy mean that much of the impact of previous hikes has yet to appear — and that forecasters shouldn’t read too much into one month’s data.

“It’s a very difficult position because one has to consider the length of the lag between any moving policy and the impact on the economy,” he said.

Yet rather than bolster the pound, the prospect of tighter monetary policy sent the currency to a two-month low against the dollar this week. That suggests investors are worried BOE rate rises will cause a serious slump.

“The pound will be the next shoe to drop, and the most obvious trade at this particular point in time,” Mark Dowding, chief investment officer at RBC BlueBay Asset Management wrote in a note.

Sterling is one of the best performing currencies among Group-of-10 this year and has weathered the impact of a resurgent dollar, thanks largely to a wide interest-rate differential. Its resilience is even more striking given the market is slowly waking up to the idea that the US Federal Reserve may continue raising interest rates this year.

“Rate hike expectations are supportive but that could give way at some stage if UK inflation is viewed as more problematic and growth expectations worsen,” Derek Halpenny, head of global markets research for EMEA at MUFG Bank, wrote in a note.

If the UK does raise rates by another percentage point, as is priced by markets a “recession seems certain,” said Societe Generale’s chief currency strategist Kit Juckes. 

The repricing is filtering through to the gilt market, the worst-performing in the world this week. Yields across the curve spiked higher and are trading at levels last seen during Liz Truss’ disastrous financial plan. The extra premium investors demand to hold 10-year UK bonds over equivalent US Treasuries is close to the highest it’s been in a decade. 

Read more:

  • UK INSIGHT: Brutal Bond Selloff Puts a Recession Back in Play
  • IMF Upgrades UK Growth But Warns Rates May Need to Rise More
  • UK Households Can Withstand Rates of Up To 5%, BOE Says
  • UK’s Stubbornly High Inflation Fuels Bets for Higher Rates
  • Pound’s Rally Is at Risk Given Sticky UK Inflation, BlueBay Says
  • UK Price Shock Sends Bond Yields to Levels Last Seen Under Truss

--With assistance from Greg Ritchie and Andrew Atkinson


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