The Bank of England Delivered a Historic Rate Hike Despite Impending Recession

Historic Hike

The Bank of England is traditionally conservative in its rate adjustments and despite having started its hike-cycle before most of its major peers, almost a year ago, it has been constrained to small changes. As this strategy did not work and inflation continued to soar, it broke with convention, delivering bigger 0.5% increases at each of the previous two meetings.

Today it went a step further with an even more aggressive hike of 75 basis point ^[1], something it has not done in thirty-three years. The Bank Rate now stands at 3% and the highest levels since 2008.

In typical BoE fashion though, the decision was not unanimous. Seven policy makers voted in favor of the move, but two members dissented in favor of smaller hikes, highlighting the divisions within the central bank. One voted for a 0.25% adjustments and another for a 0.5% move.

Uncertain Backdrop

Bank officials definitely have a very hard and unenviable job, as they are essentially hiking into a recession and the recent political turmoil did not make things easier. The UK has changed three Prime Ministers this year, as Mr Johnson's successor became the shortest-serving PM.

The infamous mini-budget of Ms Truss with the massive tax cuts, led to market turmoil and forced the central bank to intervene in the bond market, while GBP/USD set all-time lows.

She was eventually replaced by mr Sunak last week, the second straight PM who is not elected by the general public. Furthermore, he postponed the publication of the Medium Term Fiscal Plan from October 31, to November 17.^[2]

This adds another level of uncertainty and complexity, since the central bank made its rate decision today and updated its economic projection, without the benefit of this knowledge.

Softer Language

The historically large interest rate hike, was accompanied by a less hawkish statement compared to previous language, as rates have gone up by 290 bps in less than a year and the economy is in a perilous state.

The majority of the Committee now believes that further increases "may be required" in order for inflation to return to the 2% target, albeit "to a peak lower than priced into financial markets" pushing back against market expectations around the terminal rate.

That is more dovish than the Fed's guidance, which runs its most aggressive tightening cycle in at least three decades. Despite preparing market for a slowdown, it ruled out any pause yesterday. In fact, Chair Powell appeared rather hawkish, saying that the terminal rate may eventually be higher than projected in September (4.6% median).^[3]

Recession & High Inflation

While other central banks have easily dismissed fears of economic contraction, the BoE has been way gloomy around the outlook of the British economy. Today's updated Monetary Policy Report lays out a "very challenging" outlook, projecting a "prolonged recession" well into 2024.

The Consumer Price Index (CPI) was 10.1% in September and forty-year highs, and the bank expects it to increase further to around 11% in the fourth quarter, which is however lower than the 13% it forecast in August. CPI Inflation will stay in double digits in Q1 2023 and is not projected to move below the 2% target before 2024.

Market Reaction

GBP/USD dropped yesterday after the Fed's decision, as Chair Powell struck a hawkish tone, despite hinting to a moderation in the pace of rate increases. Today it continued to decline and faced more pressure after today's outcome.

Despite the historically large rate increase by the Bank of England and the fact that officials still expect more tightening, as its softened its rhetoric and the policy differential remains unfavorable.