The Government’s cap on energy bills is likely to reduce peak inflation in the UK and dampen inflation expectations. But as disposable incomes are boosted, the cap is likely to raise medium-term price pressures. So, the EY ITEM Club expects the Monetary Policy Committee (MPC) to raise Bank Rate by 50bps in September's meeting, with an outside chance of a larger move.
Because the cap means lower near-term inflation but better prospects for growth, the outlook for interest rates appears complicated. The MPC’s prioritisation of tackling inflation over supporting activity implies that its tone may become less hawkish. On the other hand, the committee may feel compelled to follow in the footsteps of the European Central Bank and US Federal Reserve, which both recently raised policy rates by 75 basis points.
Gilt yields have risen substantially, and the energy bill cap means issuance will be higher than thought. But the EY ITEM Club thinks the Bank of England is likely to stick with plans to sell gilts. With the schedule and scale of quantitative tightening set out, any market reaction is expected to be on a small scale, although what would be a step into uncharted waters presents another risk to the outlook.
Martin Beck, chief economic advisor to the EY ITEM Club, says: “The Government’s move to cap energy bills has shifted the backdrop to the Monetary Policy Committee's next policy decision, which will be announced on 22 September. The cap means inflation is likely to come in well below current forecasts in the near term and could dampen inflation expectations.
“The EY ITEM Club now expects CPI inflation to peak below 11% in October. Had the cap not been introduced, inflation was likely headed for 14%-15% early next year. A much lower peak – which may dampen inflation expectations among the public – could also reassure the MPC. On the other hand, lower-than-expected energy bills would support disposable incomes and spending, implying that inflation may be higher in the medium term because of the cap. So, the net effect on the committee’s view on inflation appears ambiguous.
“Aside from energy price influences, the MPC will likely be mindful of a still-tight jobs market and the risk this feeds through into wage inflation. Although the level of job vacancies continued to fall over the summer, pointing to a cooling in demand for workers, constraints on the supply of workers appear to have intensified, with participation falling notably in the latest data.
“More positively, CPI inflation in August of 9.9% was in line with the MPC’s prediction, rather than surprising to the upside, as has often been the case recently. And the latest S&P Global/CIPS surveys were a little less gloomy on the inflation outlook. August's manufacturing survey showed a fall in balances for input prices and prices charged, and the services survey also pointed to cost pressures easing a little.
“On balance, the EY ITEM Club expects Bank Rate to rise 50bps in September's meeting. However, a minority of MPC members may vote for a larger 75bps increase, motivated in part by a perceived need to keep up with the US Federal Reserve and European Central Bank and prevent further inflationary falls in the pound. September's meeting will also see a new member join the committee, adding another element of uncertainty.
“The worsening inflation outlook, climbing market interest rate expectations, and the likelihood of a further fiscal loosening have probably all contributed to a substantial rise in gilt yields over the past month, as well as UK government bonds underperforming their US and European peers. These developments complicate the Bank of England's plans to start selling gilts – 'quantitative tightening' – as does the prospect of higher government gilt issuance to pay for the energy bill cap.
“The EY ITEM Club thinks the MPC will stick to guidance set out in August’s policy statement and vote in favour of the commencing sales of gilts this month. With the Bank of England having already set out the schedule and scale of quantitative tightening, any market reaction is expected to be relatively insignificant. And by taking small steps, the Bank of England could stop if it sees evidence of a negative market reaction. Still, what will be a step into uncharted waters presents another risk to the outlook.”