Press release

1 Nov 2022 London, GB

Tax U-turns and more settled markets could temper rate increase – EY ITEM Club comments

Martin Beck, Chief Economic Advisor to the EY ITEM Club, looks ahead to this week’s Monetary Policy Committee meeting.

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  • Tighter fiscal policy and calmer financial markets mean the risk of the Monetary Policy Committee (MPC) delivering an unprecedented rise in interest rates has been reduced significantly. Indeed, there’s a chance that Bank Rate may increase by only 50bps in November’s meeting, compared with expectations of 150bps only a few weeks ago. On balance, the EY ITEM Club expects a 75bps rise, albeit with the committee divided, and for the policy rate to peak no higher than 4% next year.
  • Tightening monetary policy to any degree can still carry risk. Recent indicators of economic activity have been mostly downbeat, while there have been further signs that pipeline price pressures are easing. But the MPC will be mindful of a still-tight jobs market, while the end of the Energy Price Guarantee next April could prompt an increase in inflation. 
  • The Bank of England appears likely to stick with plans to sell gilts bought under the Quantitative Easing (QE) programme.

Martin Beck, chief economic advisor to the EY ITEM Club, says: “The short period since the MPC's last meeting in late September has seen a combination of financial market and political turbulence with few recent precedents. The good news for the MPC ahead of its next decision is that the backdrop has calmed significantly. This has been aided by U-turns on most of the tax cuts announced in the ‘mini-Budget’ on 23 September and by the prospect of fiscal policy being tightened further in November's Autumn Statement.

“Only a few weeks ago, markets expected that reasserting macro credibility, counteracting the inflationary effect of looser fiscal policy and preventing a further fall in sterling would require the MPC to raise Bank Rate by as much as 150bps. Those expectations have now receded to 75bps, and there’s a realistic chance even this may prove too hawkish. Recent economic indicators have been almost uniformly downbeat. GDP fell 0.3% month-on-month in August and the economy likely shrunk in Q3 by more than the 0.1% expected by the MPC. A weak set of flash PMIs for October also point to a poor Q4.

“Although inflation is still high, the outlook has become less concerning. Leading indicators of price pressures, such as gas prices, shipping costs and money supply growth, have all fallen back. And falling GDP, higher mortgage rates, U-turns on tax cuts, and the prospect of greater restraint on public spending all imply weaker demand and, all else equal, less pressure on inflation.

“Granted, the MPC's concerns about the inflationary risks of a tight jobs market will have been reinforced by a further rise in inactivity over the summer and regular pay growth at a record high outside the pandemic period. And if the end of the Energy Price Guarantee next April is followed by household bills reverting to wholesale prices, the implication would be another significant rise in inflation from Q2 2023.

“On balance, the EY ITEM Club expects the MPC to raise rates by 75bps this week – although a smaller 50bps increase wouldn’t be a surprise. That would be consistent both with recent comments from some MPC members that markets have been pricing too substantial a rise in Bank Rate, and with divisions among the committee – while three members voted for 75bps in September, one voted for just 25bps.

“The Bank of England will likely stick with plans to sell gilts, due to begin on 1 November. But the EY ITEM Club thinks now could potentially be the wrong time for Quantitative Tightening (QT). It's noticeable that UK gilts began seriously underperforming US and German bonds in August, after the Bank of England raised the prospect of selling down gilts shortly after its September meeting. That plan was confirmed in September, and was followed by a further rise in yields, just before the mini-Budget-related increase. The Bank of England's statement on 28 September declaring that it would delay QT and restart gilt purchases saw yields fall markedly. These movements raise the risk that bond sales could result in renewed challenges in the gilts market. 

“It’s not clear that there’s any pressing reason for the Bank of England to stick with beginning QT soon. Bank Rate is the primary tool of monetary policy as opposed to asset sales. Other major central banks have yet to be as explicit as the Bank of England about when they'll sell their own bond holdings. And the Bank of England will be selling gilts at the same time as the Government is seeking to fund a sizeable budget deficit.”