Memo From the Bank of England: You Can’t Forecast Future Rate Moves

The BoE wrongfooted expectations Thursday.

What a difference a day makes! Before Wednesday, the vast majority of the financial world expected UK inflation to accelerate on the back of higher fuel prices, triggering the Bank of England (BoE) to raise rates to 5.5%—which would have been the 15^th straight hike—at Thursday’s meeting. But then Wednesday’s inflation report showed prices decelerating in August as food and lodging prices more than offset fuel, changing expectations on a dime. The BoE followed suit, voting 5 – 4 to keep rates at 5.25% in a move many called an overreaction to a single data point. To us, however, this is a logical response to a multi-month trend of slowing inflation, and it shows the folly of trying to guess central banks’ next moves.

In our view, there is nothing magical about August’s inflation report that should have changed rate hike expectations. Yes, it defied expectations for a reacceleration. CPI excluding owner-occupiers’ housing costs (CPIH), which is the Office for National Statistics’ headline measure, inched down from July’s 6.4% y/y to 6.3%.^[i] Plain old CPI, which headlines focus most on, slowed from 6.8% y/y to 6.7%, upending expectations for an acceleration to 7.1%.^[ii] Fuel prices rose from July, as expected, but continued disinflation outside oil and gas was more than enough to overcome it.

While this seems to be the surprise factor for those presuming inflation would reaccelerate, slowing non-fuel prices isn’t new. Food prices have slowed since peaking at 19.2% y/y in March, and August’s 1.5 percentage point deceleration matched July’s.^[iii] Home maintenance, furniture, restaurant, personal care, financial services and many other categories have also slowed for several months running. It all seems consistent with weak lending and falling money supply. Given inflation is always and everywhere a monetary phenomenon of too much money chasing too few goods and services, falling money supply should have predicted prices’ return to Earth. And it probably would have, if monetarism weren’t so unfashionable.

So no, we don’t think the BoE’s pause is an overreaction to one data point. Or two data points, given falling monthly GDP in July seems to have factored in, as the BoE cited its revised forecasts for “weaker than expected” growth in 2023’s second half. It seems an entirely logical move considering M4 money supply has fallen in 7 of the past 10 months and lending in 5 of the last 10.^[iv] If rate hikes’ purpose is to tighten financial conditions, these seem like measures of success.

Why does everyone seem to see it so differently—including nearly half the BoE’s Monetary Policy Committee? Our guess: a slavish groupthinky obsession with the Phillips Curve, which posits a link between wages and inflation. The logic: Tight labor markets raise wages, forcing businesses to raise prices to preserve margins, driving wages up, driving prices up, lather, rinse, repeat. So with wages speeding to a fresh high in the three months to July (the latest data available), there was a very, very, very loud chorus singing the BoE’s work wasn’t close to done. That chorus kept up after the BoE paused, tempered only by a smidge of speculation that perhaps the tiny unemployment rate uptick from 4.2% to 4.3% in the 3 months to July was a signal wages would soon ease, thus easing inflationary pressures.^[v]

We don’t buy that logic. In our view, wages are an after-effect of inflation, not a cause, and their acceleration has followed inflation’s spike. They will probably slow in the months ahead, lagging inflation’s slowdown just as they lagged its rise. And unemployment? It lags economic growth. Rising output begets more hiring, not the other way around. And money supply and lending lead all of it.

Not that we are touting a big Mission Accomplished on the BoE’s behalf. That isn’t the point. It is entirely possible they overshot and have already sowed the seeds of recession. We aren’t deeming this probable, but it is a possibility worth considering. Our point is this: Taking central bank guidance and consensus expectations as foregone conclusions isn’t wise. You never know when central bankers will change their minds. Heck, in this instance, it seems the BoE got an advance look at the S&P Global flash purchasing managers’ indexes that will hit the wires Friday.^[vi] If central bank decisions are data dependent and those data include metrics that aren’t yet publicly available, then how in the world can investors even pretend to assign probabilities in a reasonable, logical manner?

The good news, as we showed yesterday, is that pinpointing the BoE’s (or any central bank’s) next move isn’t necessary for investors, as markets seem to have moved on from rate hikes several months ago. UK stocks’ volatility this year may make it harder to see, but most of that comes from British markets’ high Financials, Energy and Materials concentration, giving it high exposure to oil and other commodity prices. UK markets have had plenty of big spurts during the BoE’s tightening cycle and even hit fresh highs early this year, over a year in. If rate hikes were massively bearish, that shouldn’t be the case.