Both the US Federal Reserve and Bank of England raised interest rates 25bp last week, to a target range of 0.25%-0.50% and to 0.75% respectively.
That marks the first rate rise since the pandemic for the former and the third for the latter. Both central banks acknowledged that the Ukraine crisis added uncertainty to the outlook. Both economies have seen inflation expectations rise. Both are currently experiencing high inflation rates. Both hiked rates on inflation concerns.
Signalling from the Federal Open Market Committee (FOMC) became markedly more hawkish on monetary policy, signposting a further six rate rises this year alone (the median forecast of FOMC participants). Signalling from the Bank of England, however, becomes less hawkish, with their guidance wording signalling that even raising rates once more was in doubt (“the Committee judged that some further modest tightening in monetary policy might be appropriate in the coming months” (author’s italics)).
The tone from the two was strikingly different when it came to the broader economic outlook. While US Fed Chair Powell mentioned “a strong economy… that will be able to flourish… in the face of less accommodative monetary policy,” the Bank of England sounded a much more cautious note.
In last week’s recent press conference, Chair Powell talked about the committee being “determined to take the measures necessary to restore price stability,” and at one point described what sounded like the FOMC executing a perfect ‘soft landing’: “As we raise interest rates, that should gradually slow down demand for the interest sensitive parts of the economy. And so what we would see is demand slowing down but just enough so that it's a better match with supply. And… that will bring inflation down over time. That's our plan.” That doesn’t just seem to reflect Chair Powell’s views. The median FOMC participant forecast shows the unemployment rate, for example, lower than the most recent data point and relatively flat through to 2024.
The Bank of England’s Monetary Policy Committee (MPC), by contrast, already seem to envisage a not very soft landing for the economy even without much in the way of further rate rises. In their February forecasts, based on a ‘market’ rate profile that had interest rates peaking at (only) 1.4% in 2024, the unemployment rate was forecast to be higher by early 2023, with GDP growth of only around 1% a year by 2024 and inflation below their 2% target three years out. The MPC flagged then that the main reason for the slowdown in their forecasts was the “adverse impact of higher global energy prices and tradable goods prices on UK real aggregate income and spending”. In the minutes to their decision last week, their comments were consistent with them potentially expecting even more of a slowdown: They highlighted that if recent price increases in the same prices proved persistent, that “would necessarily weigh further on UK real aggregate income and spending.”
Multiple factors help explain the difference in tone: Some of the difference in tone can be accounted for by the Bank of England having started raising rates earlier and ending quantitative easing earlier; the Bank have front-loaded their tightening by more. In the UK’s case it is also harder to attribute the latest burst of inflationary pressure as driven by an overheating domestic economy. Labour markets are tight, but aggregate pay growth is not at extraordinary levels in the UK and overall output was still slightly below Q4 2019 levels in Q4 2021. In the US, labour markets are tight, but year-on-year pay growth looks to be at its highest level for more than 30 years on some measures and real GDP was already 3.2% above Q4 2019 levels in Q4 2021. The exposure of households to high natural gas prices in particular looks less in the US, where only about half of homes use natural gas for heating (water and space), but around 86% of UK households use natural gas for heating. Year to date, benchmark US natural gas prices have not seen the same dramatic rise as UK prices either.
However, it is also possible that the US Federal Reserve is underestimating downside risks to the economic outlook posed by high inflation and/or the Bank of England is underestimating the resilience of UK consumers. For now, given weakness in US consumer confidence (specifically, the University of Michigan measure), the former arguably looks more of a risk than the latter.
A front-loaded rate path looks likely from both central banks, but the Bank of England sound like they envisage a much earlier end to this tightening cycle – and at a much lower nominal interest rate – than the Federal Reserve. The Bank of England may also make an earlier start to active quantitative tightening than the Federal Reserve whose balance sheet rolls off faster, supporting a more limited path for UK rate increases.
For now, at least one more rate rise from the Bank of England continues to look likely this year, but more rate rises look likely in the US than I’d previously expected in 2022 at seven, rather than four. That would be in line with FOMC signalling.
Both central banks will be sensitive to what happens to wage growth and inflation expectations but, all else equal, for now it seems that any renewed increases in commodity prices linked to the Ukraine crisis would likely increase the FOMC’s determination to bring inflation down but make the Bank of England increasingly uneasy about tightening monetary policy any further.
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