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A contraption at the Bank of England Museum invites visitors to experience for themselves the frustrating life of a monetary policy maker. You take control of a lever, labelled ‘Bank Rate’, and by raising and lowering it you try to get a metal ball, which represents inflation, to settle neatly at the target mark of 2 per cent.
The task is impossible. As you move your lever at one end, a mechanism continually changes the height of the other, simulating economic shocks and confounding your attempts at equilibrium. No sooner have you raised Bank Rate than you’re scrambling to lower it again.
Recent wage data have done nothing to ease concerns that the Bank of England will have to keep raising Bank Rate if it is to get on top of inflation, which is why Gilt markets are pricing in a further two to three hikes by Q1 2024. Yet there are good reasons to believe the market is being too bearish.
For starters, the US Treasury market is pricing in at least two cuts over the same period, while a full cut is priced in for the Eurozone following a December 2023 peak. The UK stands out as uniquely hawkish in the chart above, but the more dovish expectations for the Fed and ECB reflect economic trends that we would not expect to pass the UK by.
And there are already tentative signs that inflation is coming down in the UK, with July’s consumer price index showing a fall from 7.9 per cent year-on-year inflation the previous month to 6.8 per cent, and down from the October 2022 peak of 11.1 per cent.
The Office for National Statistics meanwhile has published “common trend component” analysis, stripping out volatile prices such as those for energy and fuel, which shows inflation hitting a plateau late last year and then falling between May and July 2023. Both series support the current market consensus that UK CPI inflation will spend most of 2024 in the 2 to 3 per cent range.
Then there is unemployment, which rose from 3.9 per cent in March on a three-month average basis to 4.2 per cent in June.
The BoE's case for a limited rise in unemployment rests on the view that companies will be wary of letting people go, for fear of encountering the same recruitment problems they experienced in the post-pandemic period. This acceleration in unemployment casts doubt on that assumption, as does August’s purchasing managers’ index for services, which has fallen into contractionary territory. Unemployment is now barely below the Monetary Policy Committee’s estimated equilibrium rate of 4.25 per cent, four quarters earlier than the MPC thought it would get there.
Despite these clouds, the market is currently pricing in a real interest rate of around 3.5 per cent next year, assuming a base rate of 6 per cent and that the market forecast of 2.5 per cent inflation proves correct. The last time real rates were anywhere near such territory was before the Global Financial Crisis, a time when the UK debt load was considerably smaller than today. The UK economy is now much more sensitive to debt costs. How high can Gilt yields realistically be allowed to go?
Calling the peak in yields has been a thankless task since central banks began hiking. However, it does appear that we are approaching the end of the hiking cycle, and we are becoming more bullish on Gilts. Markets move fast at inflection points, so it may be prudent to start preparing now. That Bank Rate lever can be unpredictable.