Is the Bank of England losing control of inflation and the yield curve?

Partner Content: CCLA Investment Management’s Robert Evans discusses how the Bank of England has struggled to convey its messaging on inflation and interest rates.

Photo: Shutterstock

This year is an important anniversary for the Bank of England (BoE). It represents 25 years since Tony Blair’s government gave it operational independence over monetary policy and the ability to set interest rates. One of the BoE’s main objectives is to ensure stability by setting monetary policy to achieve the government’s target of keeping inflation at 2%.

Before we focus on the recent performance of the BoE, it is important to look at the remarkable ascent in inflation levels over the last few months which has put the Bank under scrutiny. There is no single reason why the rate of inflation started to rise in 2021. Most economists agree that when economies around the world started to reopen after Covid restrictions eased, consumers, who had amassed substantial savings over the lockdown, quickly started looking to spend down some of these balances on goods and services. There had been significant disruption to global supply chains during the pandemic, and many suppliers suffered from limited stock of raw materials. This caused prices to rise during 2021 – particularly for imported goods.

Added to those factors has been a very sharp rise in energy (oil and gas) prices, as well as labour shortages in specific sectors such as haulage, exacerbated by Brexit, which has added further pressure onto prices.

The combination of these factors has pushed up prices, and we expect this will continue to be reflected in the annual rate of inflation over the coming year.

Consumer price inflation (CPI) rose at an annual rate of 5.5% in January, up from 5.4% in December and significantly above the 0.7% recorded in January 2021. This rate of CPI was more than double the BoE target of 2%.

The central bank expects the growth in inflation to continue, and to peak at more than 7.25% in April when the energy price cap is lifted, and the typical fuel bill to rise by 54%

What happens next?

Inflation is being closely watched by the BoE’s Monetary Policy Committee (MPC). It is worried that the initial surge in inflation – which the BoE stresses they have little control over – could become a lasting phenomenon as workers look to maintain their purchasing power and request enhanced pay rises. What most concerns the BoE is that the labour market to remain tight.

The latest data shows that the number of payrolled employees in January was 436,000 above the pre-pandemic level. Meanwhile the number of vacancies reached 1.3 million in the three months to January – a record high that suggests demand remains elevated at a time when the pool of workers available to fill roles continues to shrink. With such a tight market for jobs, employees are in a much stronger position to demand pay rises and it’s this fact that most concerns the BoE.

How has the BoE tried to tackle inflation?

At the start of February, the MPC sent a strong signal that it is tackling inflationary pressures by voting to double the Official Bank Rate (OBR) from 0.25% to 0.50%. This is the second-rate hike in less than three months and the first back-to-back rate hike since 2004. In somewhat of a surprise move, four members of the nine-person committee voted to raise the OBR by an even greater margin of 50 basis points to 0.75%, which would have been the single biggest increase since the BoE achieved its independence. The MPC also tweaked its guidance to indicate greater urgency regarding further rate hikes.

Previously the BoE concluded that “some modest tightening of monetary policy over the forecast period is likely to be necessary”. Now, it thinks “some further modest tightening in monetary policy was likely to be appropriate in the coming months”.

Additionally, the BoE has become the first central bank since the pandemic began to initiate the reduction of its balance sheet. Whilst UK and global activity levels returned to pre‑Covid levels towards the end of 2021, BoE Governor Andrew Bailey made clear that the decision to raise rates was not because the economy was “roaring away”; it was primarily a move to tackle higher than expected levels of inflation.

Has the BoE struggled to convey its messaging?

On 17 October 2021 Governor Bailey warned the G30 group of central bankers that the BoE would “have to act” to address a growing inflation risk that appeared to be becoming increasingly embedded in the UK economy. This was the first firm indication from the central bank that it was getting concerned about the level of inflation; previously it had viewed inflation as “transitory”, a justification that is now looking overly dismissive.

Then came two meetings of the MPC which confounded market expectations, initially by holding the Bank Rate despite Bailey’s 17 October comments, and then by raising rates just before Christmas at the height of the Omicron uncertainty. In response to criticism of this decision, Governor Bailey said that it wasn’t his job to guide markets but there was undoubtedly a loss of trust following these shock decisions.

After the February decision to increase Bank Rate to 0.50% and its indication of further modest rises to come, Governor Bailey and Chief Economist Huw Pill signalled a preference for incremental hikes as policy is tightened. Part of the argument for going slower was that a larger move could prompt an outsized market reaction. It turns out that’s happened anyway. After the February MPC meeting, money markets projected that Bank Rate would reach 1.75% in little over a year’s time. Since then, markets built up a further head of steam and priced in 0.75% of tightening by May, with Bank Rate expected to reach 2.25% next year.

It is clear a disconnect has therefore emerged between what the BoE has been trying to communicate and what the market is pricing and that it looks like the central bank has lost control of expectations. Stronger guidance is likely to be required if this divergence does not narrow in the coming weeks.

The path ahead for the Bank Rate

Our interpretation is that the MPC appears very keen to front load hikes to guard against the risk of inflation expectations spiralling. Assuming the economic data evolves in line with the MPC’s forecasts, we see a strong likelihood of a further 0.25% increase in Bank Rate in March (only one further vote is required to tip the balance). Another move in May is also now likely when the inflation spike should have reached its peak. That would take the Bank Rate to 1%, which is where we expect the committee to pause as the inflation outlook should become more subdued.

In our view, it is the risk of this demand-side inflation that could determine further moves in the Bank Rate in the second half of the year.

Managing our cash funds in this nuanced environment

Over the last two months, we have been positioning the investments within our three cash funds to allow for their net yields to quickly react to this new rate environment. Using the Public Sector Deposit Fund as an example, within the next seven days 47% of investments mature, 62% within a month and 85% in less than three months. Therefore, we should see a relatively quick readjustment in yields to any further increases in Bank Rate.

That said, we do continue to see some value in the one-year space where we have been feeding in small investments at yields well over 1%. These investments have not only served to further enhance net yields but will offer some protection against a sudden downward shift in Bank Rate expectations; that might occur should inflation drop off more quickly than anticipated, perhaps as a result of supply-chain improvements or falling demand as the cost-of-living crisis bites.

Robert Evans is a cash fund manager at CCLA Investment Management.

Disclaimer

This document is issued for information purposes only. It does not constitute the provision of financial, investment or other professional advice. Past performance is not a reliable indicator of future results. The value of investments and the income derived from them may fall as well as rise. Investors may not get back the amount originally invested and may lose money. Any forward-looking statements are based upon CCLA’s current opinions, expectations and projections. Such opinions, expectations or projections may be subject to change at any time. CCLA undertakes no obligations to update or revise these. Actual results could differ materially from those anticipated.

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