BoE Review: Opening the door to rate hikes if required

• Macro view: The BoE delivered a hawkish hold with a unanimous decision to leave rates unchanged. Amid high uncertainty, policymakers made it abundantly clear that they are focused on the risk of second-round effects with several members indicating a willingness to hike rates, if required. The easing bias was removed. Bailey later warned about reaching strong conclusions, but the messaging today certainly suggests that officials are more worried about inflation risks (i.e. unanchored expectations) and less worried about recession risks than in 2022. That suggests a more proactive approach to raising rates if energy prices remain elevated. On the other side, cuts now look a more distant prospect, even in the case of abrupt geopolitical de-escalation, with the BoE vigilant around the risk of pass-through from higher energy costs to underlying price pressures. Even in our best case scenarios we see a risk that any easing would be delayed into next year.
• Markets view: The BoE’s hawkish policy update has reinforced the gilt market sell‑off by opening the door to rate hikes if the current energy price shock proves persistent. The UK rates market is now fully pricing in 50bps of BoE hikes by year‑ However, the higher starting point for interest rates, relatively soft domestic demand, and the absence of the COVID‑related supply disruptions that amplified the 2022 energy shock all suggest that any tightening is likely to be more modest if required. Higher yields have supported a stronger GBP, but the currency’s gains have been muted relative to the scale of the adjustment in rates. This provides further evidence that yield spreads have become less influential in driving FX performance in recent weeks.

Macro view: The BoE indicates a willingness to be proactive

Policymakers are vigilant to the risk of second-round effects

The BoE left rates unchanged, as expected, but it was a hawkish hold. The vote was unanimous and the BoE dropped its easing bias (“Bank Rate is likely to be reduced further”). The BoE acknowledged that inflation “will be higher” in the near-term. It estimates that energy pricing as of 16 March would be consistent with CPI inflation peaking at 3.5% in Q3. Energy prices have since surged further and hence, if maintained, would imply headline inflation easily surpassing last year’s peak of 3.8%.

With higher inflation ahead, policymakers made it clear that they are extremely attentive to the risks around structural shifts in wage and price-setting dynamics. The statement noted that the MPC “is alert to the increased risk of domestic inflationary pressures through second-round effects in wage and price-setting, the risk of which will be greater the longer higher energy prices persist”. Looking through the statement and MPC comments, the phrase “Second-round effects” was mentioned a total of 12 times. This is not a central bank which feels comfortable looking past the energy price shock.

The 9-0 vote split was also a hawkish surprise, with the consensus for 7-2. We looked for an 8-1 split (see our preview here) but at the finish both of the lead doves (Taylor and Dhingra) decided uncertainty is elevated enough to sit this one out. It was a rare outbreak of unity on the MPC.

In the individual comments, it was notable that Dhingra mentioned the possibility of hikes in her comment saying that severe and long-lasting constraints on oil and gas supply could “warrant a hold or increase in Bank Rate to stabilise price-setting dynamics albeit creating a difficult trade-off with activity following a prolonged period of weakness.” Catherine Mann (a self-styled “activist” MPC member) also noted the possibility of a hike, while other members, including Governor Bailey and dovish-leaning Ramsden, mentioned a readiness “to act”.

After the announcement, Bailey warned about reaching strong conclusions from the message today. There is certainly a wide range of possible paths ahead. Despite the elevated risks of a protracted conflict and disruption to energy production, the prospect of abrupt geopolitical de-escalation is always plausible under the Trump administration. In that case, we assume that some risk premium would remain in energy prices and UK inflation would still drift higher. If so, the BoE would likely remain on hold for a protracted period while monitoring the pass-through from the shock to underlying price pressures. Pre-conflict, we expected rates would be cut to a terminal rate of 3.25%. Even in the case of swift de-escalation, we think the BoE would be reluctant to get down to that mark in a hurry unless the demand environment were to deteriorate and hence there would be scope for at least one cut to be postponed to 2027.

In terms of hikes, it certainly seems that the bar is not as high as we had previously assumed. Even if energy prices and uncertainty are elevated next month, we’re not convinced there’s any need for urgency. Policy is still in restrictive territory and the energy price cap system shielding consumers initially from higher bills until July. Officials will also watch for a fiscal response – there have been some indications from the Chancellor that policy interventions could offset the inflationary impact of higher energy prices. Against that backdrop, and given the risk of making a policy mistake, we still believe that policymakers will want to see at least some signs of actual pass-through in the form of rising pay settlement surveys and other wage data to justify a move, which might reduce the chances of any action at the next meeting in April.

The BoE did also acknowledge that circumstances are different to the previous energy shock: “In contrast to … 2022, this shock was occurring at a point when growth was below potential and the economy was operating with a margin of spare capacity”. But the messaging today certainly suggests that officials are more worried about inflation risks (i.e. unanchored expectations) and less worried about recession risks than last time – and may take a more proactive approach to raising rates. 

BoE rate expectations have shifted markedly as energy prices have surged

Some tentative signs that the UK jobs market may have turned a corner after the Budget

Markets view: Gilt market continues to underperform while more muted reaction for GBP 

BoE opens door to rate hikes lifting UK yields & GBP  

The most significant market reaction to today’s BoE policy update has been in UK rates. The hawkish shift in policy communication has reinforced the ongoing sell‑off, leading to further underperformance in gilts. The move has been most pronounced at the short end of the curve, with the 2‑year gilt yield rising by around 30bps, compared with an increase of roughly 10bps in the 10‑year yield. As a result, the 2s10s gilt curve has flattened by almost 50bps since early February. This sharp flattening has been driven primarily by an abrupt hawkish repricing of BoE rate expectations. Following today’s policy update, the UK rates market is now fully pricing in 50bps of BoE rate hikes by year‑end, whereas before the Middle East conflict it had been pricing in around 50bps of cuts. Today’s updated communication from the BoE made it clear that MPC members are preparing to raise rates if the energy price shock proves to be more persistent. The attacks on energy sites in the Middle East by Israel and Iran over the last 24 hours have increased the risk of a more prolonged energy price shock, contributing further to the gilt‑market sell‑off.

However, the BoE did not provide any indication of how much rates might ultimately need to rise. Governor Bailey cautioned against jumping to strong conclusions on the scale of potential hikes, stressing that rates are already high, domestic demand is relatively soft, and the COVID‑related supply disruptions that amplified the 2022 energy shock are no longer present. The BoE also noted that a larger energy price shock would weigh more on growth, which in turn could help dampen medium‑term inflation pressures and reduce the need for aggressive policy tightening. Overall, today’s communication aligns with our view that any rate hikes are likely to be far more modest than during the last energy shock in 2022, when the BoE raised rates by a cumulative 325bps. The BoE may still avoid raising rates altogether if the energy shock proves short‑lived although, given recent developments, that scenario now appears considerably less likely.

FX vs. Yield spread changes since Middle East conflict began

Source: Bloomberg, Macrobond & MUFG GMR

In the FX market, the GBP initially strengthened in response to the hawkish repricing of BoE rate expectations, although the reaction was only modest. Cable rose to a high of 1.3374, while EUR/GBP declined to a low of 0.8617. The relatively muted move in the GBP set against the much larger jump in UK rates highlights that yield spreads have become less influential in driving FX performance in recent weeks. European currencies, including the GBP, have weakened against the USD following the energy price shock, largely because market participants  expect European economies to suffer more than the US from higher energy costs. It has meant that GBP has fallen against the USD even though markets have delivered a much more pronounced hawkish repricing for the BoE than for the Fed. By contrast, the relationship between EUR/GBP and yield spreads has remained firmer. EUR/GBP has moved lower in recent weeks as yields have risen more sharply in the UK than in the eurozone.