Market Talk: Bank of England to 'leave the door ajar' for cuts | REUTERS

Key Concepts

• Bank of England (BoE) Monetary Policy Committee (MPC): The body responsible for setting interest rates in the UK.
• Interest Rate Cuts: Reductions in the central bank's benchmark interest rate, aimed at stimulating economic activity.
• Inflation: The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.
• Headline Inflation: The total inflation rate, including volatile components like food and energy prices.
• Average Hourly Earnings: A measure of wage growth in the economy.
• Fiscal Policy: Government actions related to spending and taxation, as outlined in a budget.
• Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
• Hawks: MPC members who tend to favor higher interest rates to control inflation.
• Doves: MPC members who tend to favor lower interest rates to stimulate economic growth.
• Basis Points (bps): A unit of measure equal to one-hundredth of a percentage point (0.01%).
• Sterling: The currency of the United Kingdom (GBP).
• Gilts: British government bonds.
• Neutral Rate: An interest rate that is neither expansionary nor contractionary for the economy.

Bank of England's Interest Rate Decision: Cut or Hold?

The Bank of England (BoE) is facing a critical decision regarding its interest rates, with a potential deviation from its established quarterly cutting rhythm. While the prevailing expectation is for the BoE to hold interest rates steady at its upcoming meeting, some analysts suggest that markets might be underestimating the likelihood of a cut. This decision is further complicated by the impending budget announcement from Chancellor Rachel Reeves, raising questions about whether policymakers will opt for caution or proceed with a rate cut.

Economic Picture and Inflation Trends

Jeremy Stretch, Chief International Strategist at CIBC Capital Markets, highlights that Governor Bailey's September statement emphasized close monitoring of economic evolution. Subsequent data has shown positive developments:

• Inflation: September's inflation figures came in below market and BoE expectations, suggesting that headline inflation may have peaked below 4%. This is considered positive news.
• Wage Growth: Average hourly earnings have begun to soften, which is favorable for those anticipating rate cuts.

However, the economic picture is not entirely clear-cut:

• Q2 Data Resilience: The second quarter data has shown resilience, indicating that the economy has not weakened as much as some might have expected.
• Budgetary Uncertainty: The upcoming budget announcement introduces a significant element of uncertainty. Without this, the probability and expectation for a policy adjustment at the current meeting would have been substantially higher.

The Decision to Hold and Future Outlook

Given the budgetary uncertainty, the BoE is likely to decide it is prudent to keep policy on hold. However, the door is expected to remain "very much ajar" for a December cut, potentially maintaining the once-a-quarter cutting profile, albeit with a slightly different timing than previously seen in monetary policy reports.

• December Cut: A cut in December is considered probable.
• Sequential Cuts: There is a possibility of sequential cuts in February as inflation continues to decline and/or the prospect of fiscal tightening emerges.
• Vote Expectation: The upcoming vote is anticipated to be close, with a likely 6-3 split in favor of no change.

Market Expectations and Sterling's Performance

The consensus among some major banks is shifting towards a cut at the upcoming meeting. However, if a cut does occur, it does not necessarily rule out another move in December.

• Hawks' Reluctance: The "hawks" on the Monetary Policy Committee (MPC) are expected to be very reluctant to embrace easing at this juncture.
• Influential Voices: The decision will likely rest on the views of three "bank insiders," including Governor Bailey and Sarah Breeden. Both have voted in tandem since Breeden joined the committee in late 2023, making a policy adjustment from them at this meeting a surprise.
• Market Amplification: If the BoE were to cut rates, the market would likely amplify rate cut expectations. This has been a contributing factor to sterling's underperformance in recent weeks, particularly since the benign CPI print.
• February Pricing: Markets are currently pricing in just over 30 basis points for the February meeting, suggesting there might still be scope for a more aggressive stance even if the BoE does not alter its guidance alongside any vote.

New Communication Style and MPC Divisions

This meeting marks the debut of the BoE's new communication style, where forecasts will be published based on the majority view. However, it is not expected to lead to less division within the MPC.

• Individual Stances: The new approach provides an opportunity for individual members to outline their personal stances, potentially enhancing communication.
• Underlining Differentials: This is likely to underline the differential positions and standpoints of various MPC members rather than fostering a more convergent view.
• Healthy for Markets: This transparency in individual biases is considered healthy from a market perspective.

Fiscal Challenges and Sterling's Reaction

Rachel Reeves's recent speech outlining the UK's fiscal challenges has already had an impact on sterling.

• Gilt Rally: In the fixed income space, gilts rallied during the early phases of Reeves's speech when she discussed "ironclad fiscal discipline."
• Market Disappointment: Markets were slightly disappointed by the lack of detailed fiscal measures, though this was somewhat expected given the proximity to the budget.
• Sterling Underperformance: Sterling has been a net underperformer, partly due to increased rate cut expectations. A brief surge in expectations for a December cut to nearly 20 basis points yesterday was a catalyst for this underperformance.
• Future Sterling Outlook: If a more aggressive monetary easing policy emerges in the first quarter, it could keep sterling on the defensive. Conversely, faster-than-expected monetary easing might influence the consumer and growth narratives.
• Opportunity for Sterling: This could present an opportunity to buy sterling at cheaper levels in early next year, assuming the BoE holds rates at a neutral level of 3.5% from the middle of Q1 onwards.

Conclusion

The Bank of England faces a complex decision, balancing positive inflation and wage data against economic resilience and significant budgetary uncertainty. While a hold on interest rates is the most probable outcome for the current meeting, the BoE is likely to signal a potential cut in December and possibly in February. Market expectations for future cuts are still developing, and sterling's performance will be closely tied to these evolving monetary policy signals and the government's fiscal plans. The new communication style of the MPC is expected to provide greater insight into individual members' perspectives, potentially leading to a more nuanced understanding of policy debates.