The BOE is facing a somewhat unique problem that could lead to a divided vote on policy when it meets tomorrow. And that could send a confusing signal to the markets, leading to unexpected moves in Forex. Here’s why 25, 50 and 75 basis points are all up for discussion:
The tortoise didn’t beat the hare
The BOE was the first bank to start tightening during this cycle, leading to some speculation that the UK could handle the inflation situation better than its peers. However, other central banks, and in particular the Fed, hiked much faster and quickly overtook the BOE. The plodding pace of rate hikes didn’t blunt the steady rise in inflation, leading the UK to have some of the lowest real yields among the majors. Naturally, this contributed to the pound becoming weak, and it touched decades low levels against the dollars.
A weak currency only exacerbates inflationary pressures, as imported goods (or goods priced in dollars, such as natural gas and oil) increase in price even more. Finally, at the last meeting, the BOE decided to hike rates by 50 basis points, leaving the rate at 1.75 compared to 2.5 in the US.
The unique situation
Inflation was expected to continue to rise through the rest of the year, potentially peaking at 14%. This would necessitate the BOE to take aggressive action, despite warning of an impending recession. At that point, inflation was already in double digits, also something not seen in decades.
Then the new PM announced a program to cap energy prices. And this is where things get really complicated. For starters, the exact details of the plan won’t be known until Friday. On the one hand, increased government spending could lead to higher inflation. On the other, capping prices for energy, particularly for businesses, would likely contribute to slowing the headline inflation rate.
What about the BOE
The thing is, the BOE cares about the core rate; that is, the amount of inflation without the high variability caused by energy and food prices. Headline inflation has already come down a bit, but core inflation continues to rise. But, how much of that core inflation is due to the effects of increased energy prices affecting transportation and operating costs? Some of that effect could then be mitigated by the government’s price cap. But, again, we don’t have all the details; and the BOE will have to decide based on the information it has now.
That’s why there is an argument that the BOE doesn’t need to keep hiking as aggressively, since inflation could be mitigated by slower economic growth and government action. This could be the position of Tenreyo, who dissented last time, voting for a 25 bps hike. And she could do that again this time.
Some BOE members potentially voting for 75bps, particularly if the Fed goes for the full percentage point later today. Thus, there could be a three-way split in the vote. Most economists expect that 50bps will win out in the end. But how the market could react likely will depend on the vote split, and how much the board inclines towards either 25 or 75bps.