A ‘cocktail’ of sticky inflation and a tight labor market boosts bets on Bank of England rate hikes

LONDON — A tight labor market and a relatively slow return to earth for inflation mean the Bank of England is likely to push ahead with a further rate hike in March, economists suggest.

The market probability of a further 25 basis points increase at the next meeting of the Monetary Policy Committee rose above 73% on Wednesday and fell back to around 66% by Thursday morning, according to data from Refinitiv.

Annual inflation in the UK fell for a third consecutive month to 10.1% in January, below consensus forecasts, even as high food and energy prices continue to weigh on UK households.

Although inflation is on the decline, the rate of price increases slowed by only 1% between October and January – a relatively small decline compared to that seen in other major economies.

“With the FTSE 100 hitting record highs recently, investors should be somewhat reassured by the direction of the price,” said Richard Carter, head of fixed rate research at Quilter Cheviot.

“However, food prices remain a key driver of UK inflation and continued their advance in January with an eye-watering 16.8% increase. Food industry bosses have warned that it will be some time before prices fall.”

Tuesday’s employment data for December also gave little indication that the labor market is beginning to ease, with the unemployment rate remaining at 3.7%. Growth in average weekly income excluding bonuses rose to 6.7%, an 18-month high, during the last three months of 2022.

Along with the shortage on the supply side, the UK is navigating widespread industrial action among public sector workers as wage increases lag inflation.

Bank of England Governor Andrew Bailey last week urged workers and employers to take the projected downward trajectory of inflation into account when negotiating pay arrangements.

“The cocktail of a tight labor market and inflation that is not cooling down quickly will continue to be a concern for Bank of England policymakers, which may mean that the bank’s aggressive strategy remains intact,” Carter added.

The UK narrowly escaped recession in the fourth quarter as growth stagnated, but the MPC sees a shallow recession starting in the first quarter of 2023 and lasting for five quarters.

“Despite a slowing economy, wages are still rising rapidly against a background of stagnant labor supply, which threatens to keep service inflation high,” said Hussain Mehdi, macro and investment strategist at HSBC Asset Management.

This means the Bank’s Monetary Policy Committee is likely to pass another rate hike next month, with some chance of further tightening at subsequent meetings if wage growth measures fall short of the Bank’s 2% target.

January’s inflation rate of 10.1% was right in line with the Bank’s projections, with four of the twelve divisions of the consumer price index (CPI) making downward contributions to headline inflation. The biggest drop came in the form of a 7.2% year-on-year decline in used car prices, while gasoline and diesel price inflation also cooled further.

“The Bank of England will be pleased to see service inflation starting to ease, as it tends to be more stubborn than goods inflation,” said PwC economist Jake Finney.

“They will also be reassured by the latest data indicating that private sector wage growth is slowing down. Our view, however, is that the Bank of England has not seen enough to shift the dial – so we expect them to take another last rate of 25 bp will deliver hike in March.”

Market response

Despite higher market prices ahead of a further 25 basis point hike in March, UK government bond yields fell sharply across the yield curve on Wednesday morning before recovering slightly. The yield on 2-year gold-plated government bonds was little changed early Thursday at 3.75%, while the 10-year yield hovered around 3.47%.

James Athey, investment director at Abrdn, told CNBC on Wednesday that the bond market’s seemingly dovish interpretation has brought some relief. But he pointed to the similar data pattern in the US in recent months, noting that “it only took a few data points for the market to begin significantly revising its outlook for policy.”

Athey suggested that government bond positioning had significantly influenced the yield movement, with excessive positioning at the short end of the curve in recent weeks declining and causing the front end to underperform.

“So I think we got to the point where the positioning was either cleaner or a bit short in UK rates, and so the marginal progress on inflation has delivered a pretty strong rally this morning.