In Brief

• The Bank of England (BoE) raised the Bank Rate by 25 basis points (bps) to 1.25% in a split 6-3 vote, with dissenting Monetary Policy Committee (MPC) members calling for an immediate jump to 1.50%.
  
  
• Continuing robust global inflationary pressures, in combination with a tight labour market, warranted a fifth consecutive rate hike and a commitment that the MPC “will if necessary act forcefully in response” to indications of more persistent domestic price pressures.
  
  
• With Bank Rate at its highest level in over a decade, ultra-low yields are fast becoming a distant memory for cash investors. However upside risks to inflation remain and the trade-off between clamping down on inflation and slowing growth will continue to add to interest rate volatility.

Slow and steady

Markets were expecting a 25bp rate increase from the BoE at its June meeting (Figure 1) and that’s what was delivered, as the MPC voted to raise the Bank Rate to 1.25% (Figure 2). The BoE was the first major developed central bank to start hiking rates in late 2021, and the latest move affirms its commitment to a slow and steady progression towards normalised interest rates, even as an increasing number of central banks pivot to larger rate increases – just this month the US Federal Reserve raised rates by 75bps, while the Swiss National Bank and Reserve Bank of Australia both hiked by 50bps. Six MPC members voted for a 25bp hike in order to return inflation towards the 2% target in the medium term, however a minority trio judged that a faster pace was required to lean more strongly against the recent rise in pay growth and inflation expectations.

Figure 1: Market expectations prior to the decision

Source: J.P. Morgan Asset Management and Bloomberg. Calculated using OIS forwards to Bank of England meeting dates. Data as at 15 June 2022.

Figure 2: UK Bank Rate is at 1.25% for first time in over a decade

Source: J.P. Morgan Asset Management and Bank of England. Data as at 16 June 2022.

And ready to act forcefully!

The divergent views on the MPC highlights the dilemma the BoE faces over future policy moves. Consumer Price Index (CPI) inflation is now expected to rise to over 11% in October 2022 and while this is mostly driven by external factors, including higher household energy costs which are expected to wane over time, domestic price pressures and inflation expectations have also strengthened. The unemployment rate in the three months to April was 3.8% – equal to the pre-pandemic trough – and there is evidence of continued recruitment difficulties and elevated nominal pay growth. The sterling effective exchange rate, the weighted average of the value of the pound versus other major currencies, has depreciated 2.5% since the previous MPC meeting and could weigh further on the economy through higher prices on imported goods. Therefore, the MPC has explicitly committed to “be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response”.

Path of rates still uncertain

Compounding the BoE’s challenge, tighter monetary policy and weaker real incomes will serve to curb domestic demand, and Bank staff expect growth to slow to 0.3% in the second quarter 2022. While some of the contraction in the economy can be attributed to temporary factors, if the Bank opts to significantly tighten monetary policy further, it could risk exacerbating the projected recession. This means that the scale, pace and timing of future tightening will need to reflect the necessary balance between the economic outlook and inflationary pressures.

Investor implications

Sterling cash investors should welcome this further increase in Bank Rate as improved overnight rates allow liquidity and ultra-short duration strategies to boost returns – albeit with a slight delay due to the need to reinvestment maturities.

However, the trade-off between inflation and growth and the uncertainty surrounding the risks suggests bond yield and curve volatility could remain high. The increased risk of capital losses on longer duration strategies should warrant a disciplined approach to cash segmentation and by prioritising a combination of money market and ultra-short duration strategies, sterling investors can aim to optimise returns without excessively increasing risk or volatility.

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