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Bank of England set to raise rates again, but by how much?

Bank of England

European markets fell for the third consecutive day yesterday, after the IFO in Germany warned that a recession would be sharper than expected in the second half of the year, and UK core inflation unexpectedly jumped to a new 32-year high. 

US markets also fell for the third day in a row after Federal Reserve chair Jay Powell doubled down on his message from last week to US lawmakers yesterday, that US rates would need to rise further to ensure inflation returns to target. This weakness in US markets looks set to translate into a lower European open, as we look towards another three central bank rate decisions, from the Swiss National Bank, Norges Bank and the Bank of England, all of whom are expected to raise rates by 25bps today. 

Up until yesterday’s CPI number, markets were predicting with a high degree of certainty that we would see a 25bps rate hike from the Bank of England later today. That certainty has now shifted to an even split between a 25bps and 50bps hike, after yesterday’s sharp jump in core CPI to 7.1% in May. As inflation readings go, it’s a very worrying number and suggests that inflation is likely to take longer to come down than anticipated, and even more worrying price pressure appears to be accelerating, in contrast to its peers in the US and Europe where prices now appear to have plateaued. This has raised the stakes to the point that the Bank of England might feel compelled to hike rates by 50bps later today, and not 25bps as expected. Such an outcome would be a surprise from the central bank given their cautious nature over the years, however such has been the strong nature of recent criticism, there is a risk that they might overreact, in a sign that they want to get out in front of things. 

Whatever they do today it's not expected to be a unanimous decision, but the surge in core inflation we’ve seen in recent months does make you question what it is that Swati Dhingra and Silvana Tenreyro are seeing that makes them think that the last few meetings were worthy of a no change vote. In the absence of a press conference to explain their actions, a 50bps rate move would be a risky strategy, as it could signal they are panicking. A more measured response would be to hike by 25bps, with a commitment to go more aggressively at the next meeting if the data warrants it. The big problem the Bank has is that they won’t get to see the July inflation numbers, when we could see a big fall in headline CPI, until after they have met in August, putting us into the end of Q3 until we know for certain that inflation is coming down. 

The resilience in UK core inflation has got many people questioning why it is such an outlier compared to its peers however if you look closely enough the reason is probably staring us in the face in the form of UK government policy and the energy price cap, which has kept gas and electricity prices artificially high for consumers. 

If you look at the price of fuel at the petrol pump. it's back at the levels it was prior to the Russian invasion of Ukraine, due to the slide in oil prices from their peaks of $120 a barrel, with consumers already benefiting from this disposable income uplift into their pockets directly in a lower bill when it comes to refilling the family car. Natural gas prices have gone the same way, yet these haven’t fed back into consumers’ pockets in the same way as they have in the US and Europe.

This has forced employers here, in the face of significant labour shortages, to increase wages to attract the staff they need, as well as keep existing staff to fulfil their business functions. We already know that average weekly earnings are trending upwards at 7.6% and in some sectors, we’ve seen wage growth even higher at between 15% and 25%. These increased costs for businesses inevitably feed through into higher prices in the cost of delivering their services, and voila you have higher service price inflation which in turn feeds into core prices, in essence creating a price/wage spiral. 

It is perhaps a supreme irony that an energy price cap that was designed to protect consumers from rising prices is now acting in a fashion that is making UK inflation a lot stickier, and making the UK’s inflation problem a lot worse than it should be. So, while a lot of people are blaming the Bank of England for the mess the UK is in, we should also direct some of the blame at the energy price cap, a Labour Party idea that was hijacked by the Conservatives and is now acting as moron premium in the UK gilt market. 

It is these sorts of poorly thought through political interventions that always have a tendency to come back and bite you in ways you don’t expect, and the politicians are at it again, with the Lib Dems calling for a £3bn mortgage protection scheme, another crackpot idea that would push back in the opposite direction and simply make the task of getting inflation under control even more difficult. 

On the plus side, there are reasons to be optimistic, with the energy price cap set due to be reduced in July, while PPI inflation has also been falling sharply, with the monthly numbers in strongly negative territory, meaning it can only be a matter of time before the year-on-year numbers go the same way. This trend of weaker PPI suggests that market forecasts of a terminal bank rate of 6% might be overly pessimistic, and that subsequent data will pull gilt yields lower, however we may have to wait another two to three months for this scenario to play out in the data. This should still feed into headline CPI by the end of the year, though core prices might prove to be slightly more difficult to pull lower. 

EUR/USD – remain on course for the April highs at 1.1095 while above the 50-day SMA at 1.0870/80 which should act as support. Below 1.0850 signals a move towards 1.0780.

GBP/USD – fell back to the 1.2680/90 area yesterday before recovering, having found resistance at the 1.2845/50 area at the end of last week. Still on course for a move towards the 1.3000 area, while above the 50-day SMA currently at 1.2510. 

EUR/GBP – found support at the 0.8515/20 area and has move up towards the recent highs at 0.8620. A move through 0.8630 could see a move towards 0.8680. While below the 0.8620 area the bias remains for a return to the recent lows.

USD/JPY – currently finding itself rebuffed at the 142.50 area, which is 61.8% retracement of the 151.95/127.20 down move. Above 142.50 targets the 145.00 area. Support now comes in at 140.20/30. 

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