MNI INSIGHT: Fed Rates Speculation Double-Edged Sword For BOE

The Bank of England will stay informed on ongoing market turbulence right up until its decision on Wednesday, if need be, but the possible impact of a weaker pound from higher U.S. rates would be offset by a tightening in UK financial conditions in a dollar-dominated system.

Speculation that the Federal Reserve will announce a 75-basis point hike on Wednesday has driven rate curves higher. The standard line from policymakers here has been that they do not ‘follow the Fed’ meeting-by-meeting, but the fact is that shifts in U.S. monetary policy and expectations can have a significant impact on UK financial conditions, becoming a factor in BOE policy decisions.

The Bank has developed a single Monetary and Financial Conditions Index, based on a range of components including the sterling exchange rate index, OIS curves and mortgage spreads. In times of turbulence the focus may be more on its sub-components than the index itself and the effect of shifting asset prices and curves can be offsetting.

Sterling depreciation, with the currency under pressure in recent days, may tighten financial conditions if sterling-denominated bond spreads widen but it will also be assumed to push up on import prices, adding to upside inflation pressures.

DOLLAR DOMINANCE

BOE policymakers are also aware that market pricing of future rate moves has become detached, in part because of dollar dominance, from what market participants think the Monetary Policy Committee is most likely to do. The peak in implied UK money market rate expectations has moved sharply higher, with the policy rate expected to rise to around 3.5% from the current 1.0% over the next year, although analysts’ views appear fragmented, with the majority in an MNI survey expecting Bank Rate to end 2022 in a 1.50%-2.00% range.

In its May Monetary Policy Report, the Bank noted that at that time UK, the market-implied path for Bank Rate was for it to rise to around 2% by the end of this year and to peak a little over 2.5% in 2023, but that this was markedly higher than the expectations of market participants in its in-house survey.

Similar fragmentation of market pricing and market views are evident this time around, highlighting to policymakers the limitations of attempting to ‘talk to the curve’.

Analysts’ surveys and market pricing still indicate a strong likelihood that the MPC will hike 25 basis points this week, with its August forecast round allowing it to reassess the situation. In extreme cases the MPC, which only announces the outcome of its meeting midday Thursday, could delay its vote but practicalities weigh against this. (See MNI INSIGHT: BOE Rates Guidance Underplays Tightening Bias)