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.
Author: Azad Zangana, Senior European Economist and Strategist and Grace Canavan, Head of Intermediary Business Development, Ireland. Website www.Schroders.com and contact number +353 (0) 85 254 9839.
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.