Central banks stick to their plans – with one eye on possible shocks

In the run up to June’s Monetary Policy Committee rate decision, most domestic indicators appeared to be pointing in a dovish direction. The labour market has continued to loosen according to numerous metrics. For example, the unemployment rate remains on an upward trajectory, payroll numbers have dropped for seven months running, and vacancies are still falling. Moreover, while remaining elevated, wage rates are showing signs of cooling and Q1’s strong growth went into reverse in April with a m-o-m print of -0.3%.

Yet this still was not enough to convince a majority on the MPC to cut rates in June, as I discussed in a CNBC interview Opens in a new window  when the decision was announced. While three members were convinced that monetary policy could be eased by 0.25pp, the other six members voted to hold rates at the current level of 4.25%. Most members on the committee argue that risks to the medium-term pathway of CPI are “two-sided”, meaning they believe that upside risks to inflation remain material. This worry cannot, of course, be easily dismissed given that UK headline inflation is already projected to be north of 3% until at least April next year.

The elephant in the room at the time of the MPC decision was the escalation of conflict between Israel and Iran. At the time of writing, it appears that there has been significant de-escalation but there is clearly a reasonable chance that tensions could rise again over the course of the summer. From a macro perspective, the risks arising from conflict between these two countries – and, by extension, any associated regional conflict – will be seen primarily in the energy market. 

The UK inflation impact arising from a shock to oil prices is worth considering. As discussed in the previous Rate Wrap, UK inflation expectations are showing signs of becoming “de-anchored” (meaning the public’s long-term expectations for inflation may have risen compared to the pre-pandemic norm) which means that rate setters would need to be take any supply-shock induced spike to inflation seriously. When modelling for $100 a barrel oil prices over the course of a year and an increase of 0.5pt in inflation expectations, the increase in inflation is significant (see Figure 3) and would likely warrant a hawkish pivot on the MPC.

For now, that kind of scenario would seem unlikely. Providing domestic indicators of inflation, especially wages and services inflation, continue to show signs of disinflation and there is no unexpected oil price shock, we do appear to be on course for a rate cut in August. We continue to think the cutting cycle will proceed after August although at a cautious pace given the inflation persistence issue. However, the overall landing place for rates in this cycle remains highly uncertain and will depend on whether current and future growth dynamics are driven by either constrained supply or weak demand. This remains a source of disagreement among MPC members, something we will explore in further detail in future rate wraps. 

Daniel Mahoney, UK Economist

A reassuringly uncontroversial Spending Review

The aforementioned Spending Review from UK Chancellor Rachel Reeves was delivered on June 11, and discussed in detail by our UK Chief Economist James Sproule in his latest Fast Comment which you can read here. From a markets perspective, whilst there was some prior concern that a material fiscal loosening could prompt a strong reaction from gilt traders, it turned out to be somewhat of a damp squib. The Spending Review was generally seen as more of a reshuffling of spending priorities rather than a set of expansionary fiscal commitments. 10-year gilt yields had risen circa 6bps anticipation of Ms Reeves’ speech but this was promptly unwound throughout the afternoon, closing the day lower than where they had opened then moving even lower on the next day, helped largely by lower than expected GDP, industrial production and manufacturing production data for April.

Central bank meetings bring no major surprises

The subsequent week saw a host of major central bank meetings, starting with the US Federal Reserve on July 18.  In the build-up to the meeting markets were pricing in merely a 0.8% chance of a cut, so the eventual decision to hold at 4.25-4.50% was no real surprise. More interesting perhaps were the comments afterwards, stating that uncertainty with respect to the trade war was “diminished” but still “elevated”. 

The markets initially took this to be a dovish outlook, particularly given the Federal Reserve’s dot plot still showed a median expectation for 50bps of further cuts throughout 2025 (see below).

Closer examination however reveals that this sits at the very bottom of their central tendency, a less confident median of 50bps if you will. The overall change in the nineteen head state bankers’ expectations was hawkish overall resulting in a mean expectation of 32bps of cuts, closer to 25bps than 50bps.  Clearly there isn’t a strong consensus amongst the members of the FOMC, suggesting that future dot plots could be more liable to change.

Two days later on June 19 we had the latest Bank of England decision, as Daniel has discussed above. Despite the nine members of the MPC having been widely divided in May the market expectation was firmly for a base rate hold at 4.25% which was delivered as expected. 

Perhaps more unexpected was the 6-3 vote split, with three members voting for a 25bps cut, and going against the general expectation of a 7-2 split, with Deputy Governor Dave Ramsden joining long-standing doves Swati Dhingra and Alan Taylor.  Mr Ramsden has flirted with a more dovish position before and dissented in December, backing a quarter-point reduction when the majority of the committee held rates.  He is often seen as a bit of a bellwether on the committee, moving before the rest of the MPC joins him.

The MPC’s guidance accompanying the decision stuck with the wording of “gradual and careful” rate cuts which was first introduced in February. This suggests that recent swings in oil prices, tariffs and a deteriorating economic picture haven’t been enough to warrant a pivot just yet. This may have been reinforced by UK inflation data for May, released a day earlier on July 18, which slowed to 3.3% from 3.5% a month earlier. This wasn’t as much as expected (3.3%) but was accompanied by a greater than expected reduction in service-sector inflation to 4.7% from 5.4% (4.8% expected).

All in all you could describe the market impact of Bank of England’s rate decision as anticlimactic. Swap rates did lift slightly after the meeting, around 3-5bps across the curve, reflecting expectations of one further cut by the end of 2025 and a 97.4% probability of a second, but had been generally trending down throughout June and this trend was promptly resumed a few days later. 10-year gilt yields meanwhile remain around 4.50%.

Middle East tensions pose a further risk to interest rates

Perhaps of more interest to traders over the coming month will be the development of the conflict between Israel and Iran, most noticeably with the involvement of the USA in striking Iranian nuclear facilities. A material breach of the ceasefire that results in a disruption to regional oil production or to shipping through the Red Sea would likely have an inflationary impact on major economies including the UK. 

Daniel has discussed above how a rise in oil prices to $100 per barrel may impact UK inflation, but it’s worth also considering the market impact last time we had a material disruption to global energy supplies; the Russian invasion of Ukraine in February 2022. In the following three months UK swap rates rose by about 45-50bps across the curve, largely because of the impact that the war had on flows of natural gas to Europe and consequently businesses and household energy costs. 

It would be too crude to draw a direct comparison on the potential scale of impact with the situations far from identical, particularly given it’s a different energy market most at risk (oil not natural gas). Additionally global economic growth was seen to be growing in H1 2022 rather than stuttering as it may now do with the ongoing trade tensions, meaning that energy demand and swap rates were firmly trending upwards then as opposed to downwards as they are currently. Still, it does give a very relevant and recent example of how much a spike in energy prices could impact interest rates here at home in a relatively short time.

On the other hand, a lasting ceasefire could mitigate any market impact, particularly considering an oversupply of oil into international markets from Iran. Exact figures are difficult to come by as Iran isn’t the most transparent when it comes to reporting its petroleum exports, however satellite photos and other shipping data suggest that Iranian production will reach a fresh seven-year high above 3.5 million barrels a day this month, slightly up from May. In other words Iranian oil production is up, not down, despite nearly two weeks of Israeli and American bombing. Similarly other members of OPEC+ including Saudi Arabia, Kuwait, Iraq and the UAE are all producing more oil than a month ago. All things being equal, the avoidance of a wider regional conflict should see oil prices continue to be under pressure and likely remain under $70 per barrel as they were before the Israeli strikes on Iran.

Either way, the interest rates market reaction to the conflict in the Middle East has so far largely been a case of wait-and-see. UK swap rates are still generally trending consistently downwards after their spike in May and are close to this year’s previously seen lowest levels. The threat of trade tariffs remains the biggest inflationary threat to major economies, particularly with the moratorium on some tariffs due to end in the first week of July. There have been promising signs lately of a trade deal between the US and China, as well as the US and other major trade partners, set to be agreed in the coming week but much will depend on the substance of these and where they leave effective tariff rates at afterwards.

Tom Barker, Capital Markets