UK CPI inflation is likely to rise above 7 per cent in April as Ofgem’s utility price cap increases, potentially adding more than 50 per cent to energy bills.
The pressure to get inflation under control is rising. But attempting to combat this inflation with significant further increases in the policy rate would only address the problem indirectly, and could hit the domestic economy hard, choking off the current recovery in consumption and investment. This could end up being perceived as an own goal, particularly if oil output rebounds and supply chains gradually unclog this year, causing global inflationary pressures to ease of their own accord. The Bank of England’s own forecasts point to unemployment rising if its policy rate increases to 1.5 per cent by the middle of next year.
What does it mean for markets?
Increases in the policy rate may also affect the prices of both bonds and equities. Bond prices are inversely related to long-term interest rates, meaning rising long-term rates depress bond values. They are influenced by what is happening to the policy rate now, investors’ expectations for where it is going in future, plus the Bank of England’s unconventional policy tools (its purchases or sales of government bonds).
Usually when the Bank of England signals near-term policy rate increases, long-term rates rise and bonds sell off, as investors anticipate that the policy rate will continue to climb in the years ahead. This has clearly happened in the UK recently, with the 10-year Gilt yield rising from a low of less than 0.7 per cent in December to nearly 1.5 per cent today, as the Bank of England has raised its policy rate twice.
But exceptions are occasionally possible. If investors perceive that the policy rate is rising too fast in the short term, this can build expectations that the central bank will need to reverse course further down the road, and bonds rally as long-term rates fall.
In the late 1990s, the Bank of England raised its policy rate from less than 6 per cent to 7.5 per cent, but Gilts performed very well. We’re not yet at this stage in the current sequence of policy rate increases, but it is possible we could get there if the global drivers of inflation ease sharply while the Bank presses ahead with rate increases.
Meanwhile, equities can be affected by changes in the policy rate in a couple of ways. First, they are influenced by associated changes in expectations for economic growth, which are tied to expectations of future cashflows from stocks.
Context matters a lot here. It’s not all doom and gloom for UK stocks just because the Bank of England is raising its policy rate. Growth expectations are driven by plenty of other things, including the path of the pandemic and changes in fiscal policy. What’s more, around three-quarters of the revenues of FTSE 350 firms come from outside the UK economy. This means that they are far more sensitive to developments in the global economy than to those in the UK. We think that global growth will slow a bit this year, but ultimately remain healthy.
