• We expect balanced messaging from the BoE as it remains on hold this week. Officials will want to leave the door open to further easing if uncertainty subsides, while also acknowledging the possibility that policy may need to remain restrictive to reduce second-round inflation risks from higher energy prices.
• High uncertainty should see some temporary unity on the MPC. We’ve pencilled in an 8-1 vote split. The next batch of labour market data, released on the same day as the announcement, could prompt more votes for a cut. But how Bailey frames the risks will remain key on a divided MPC. At this juncture we do not expect any meaningful signals from the Governor, with a priority placed on preserving flexibility.
• The BoE has some licence to take a patient approach with policy still in restrictive territory. April will be a live meeting only if there is clear, durable de-escalation in the Middle East. We have less conviction around the immediate scope for that than we did at the start of the conflict. If uncertainty and energy prices remain elevated, then the BoE will likely stay on pause for an extended period to assess the pass-through from energy prices to wider cost pressures.
• We maintain that the scope for second-round effects is smaller than in 2021-22. The macro backdrop is different now with clear labour market slack and a sluggish growth environment. Our central scenario remains that the easing cycle will be delayed rather than derailed by developments in the Middle East.
• All that said, it’s not inconceivable that the BoE tightens policy – but the bar is high and there will be no urgency to do so. Any hike would hinge on concrete signs of pass-through in the form of rising pay settlement surveys and other wage data. We see that as unlikely to any meaningful extent given soft domestic fundamentals and the demand effects on the global economy from a protracted conflict.

Policy on hold while officials assess the geopolitical shock

Waiting for clarity

A March cut was in play after the dovish hold at the last meeting (see here), but the conflict in the Middle East now clearly leaves the easing cycle on pause. The BoE will maintain plenty of flexibility while geopolitical risk is this elevated. At this stage we expect the messaging will be balanced – officials will want to leave the door open to further easing if uncertainty subsides, while also acknowledging the possibility that policy may need to remain restrictive.

We have pencilled in an 8-1 vote split for unchanged policy, with a suspicion that uncertainty might just be high enough for one of the dovish pair (i.e. Taylor or Dhingra) to sit this one out. That said, the next batch of labour market data is another relevant variable. It will be released on the morning of the announcement and, if especially soft, could prompt more votes for a cut.

On the hawkish side, there will undoubtedly be concerns again around structural shifts in expectations passing through to wage growth. But it feels too soon for any hawks to break cover and push for a hike. If there is a swift resolution to the conflict in coming weeks, it would be hard to argue the case for persistent second-round effects. We would perceive any discussion of rate hikes in the individual MPC comments as hawkish at this juncture, but how Governor Bailey frames the discussion will ultimately remain key on a divided MPC.

Geopolitical risk approaching 2022 levels

A sharp repricing in policy expectations in Europe

We still see scope for further easing

Our pre-conflict call was for two rate cuts this year to a terminal rate of 3.25%. We maintain that for now, while acknowledging the obvious risks around the timing and extent of further easing.

Growth remains muted and there is plenty of slack in the labour market (see here). The latest monthly GDP release was broadly disappointing (0.0% M/M in January). It also showed that ‘employment activities’ provided the largest negative contribution from a single industry to monthly growth (-0.06pp). We expect labour market dynamics will remain soft, with the increase in geopolitical uncertainty possibly becoming another headwind to hiring, at the margin.

This means that the scope for second-round effects looks much smaller than it did after the 2021-22 energy shock. The backdrop then was different with labour shortages, fragmented global supply chains, recovering post-pandemic demand and high levels of household saving. Policymakers may be wary of re-fighting the last battle and placing too much weight on household expectations in different macro conditions.

We judge that, in a scenario of geopolitical de-escalation and a relatively small persistent risk premium in energy prices, UK headline inflation would rise but remain below 3%. While household inflation expectations might drift higher in this case, it’s far from clear that employees will have a great deal of bargaining power.

All told, we still see some scope for an April rate cut – provided there is credible and durable de-escalation in the Middle East. We’re still working off our initial view that the conflict will end in a matter of weeks, but have considerably less conviction given the lack of clarity around the medium-term US strategy, hostile rhetoric and increasing doubts about Trump’s ability to control developments in the region.

If uncertainty and energy prices remain elevated at the next meeting (i.e. six weeks from now) then the likelihood will increase that the BoE remains on pause for an extended period to assess the pass-through from energy prices to wider cost pressures – even in the case of de-escalation in subsequent months.

The BoE has some licence to take a passive approach given that rates are currently in (mildly) restrictive territory. The UK’s energy price-cap system will also help to shield consumers initially with recent moves in wholesale gas prices only set to show up in Ofgem’s cap from July. In the meantime, BoE officials will also hope for clarity around the government fiscal response. There have been some indications from the Chancellor that policy interventions could offset the inflationary impact of higher energy prices.

A high bar for hikes

Ultimately, we think labour market slack will dominate second-round effects on underlying inflation. But it is not inconceivable that the BoE tightens policy this year. As we wrote here, we think officials will be at least somewhat more worried about inflation risks (i.e. unanchored expectations) and less worried about recession risks than last time. Looking back, the BoE may have raised rates before the Fed but then became relatively ponderous in terms of increments. The hawks would undoubtedly push for a more proactive approach this time if energy prices were to remain high and the inflation outlook started to look like our adverse Scenario 3 in the charts below.

The long-term inflation context is also relevant – officials will not want to be remembered as the ones who ushered in a new era of structurally higher inflation after the long slog to get things under control. Nobody will dare say ‘transitory’ this time with officials wary of the risk of structural changes in price and wage-setting behaviour after another energy price surge.

But the bar for hikes is likely to be high. Policy is already restrictive. In the context of current weakness in the demand/employment backdrop we do not believe that rising household inflation expectations on the back of persistently high energy costs would be enough, in isolation, to justify hiking rates. It would take more concrete signs of actual pass-through in the form of rising pay settlement surveys and other wage data. It’s hard to see significant scope for this given soft domestic fundamentals and the demand effects on the global economy from a protracted conflict.

Three energy price scenarios...

...and our estimates of resulting UK inflation