BoE Taking The Baton Forcefully

• This week’s central bank decisions broadly resulted as expected, with the Fed and ECB hiking into data-dependent guidance, although the BOJ’s increased YCC flexibility was a low-impact development. Meanwhile, PMI data extended the weakening trends.
• Next week is the BoE’s turn, where we expect it to hike by 50bp into wage settlements that are still drifting higher, although poor BoE communication makes it a close call. EA disinflation and hikes from the RBA and BoT are the other highlights.

Policies have been the focus in a relatively quiet week for economic data.

On the political front, Alastair analysed the results of the three recent UK by-elections, which were terrible for Prime Minister Rishi Sunak, despite the Conservatives holding on in one. Pressure is mounting to resort to pre-election populism (see UK Politics: Two Out Of Three Ain’t Bad). Meanwhile, Janet Yellen’s emollient talk in Beijing of “ample room” to boost Sino-US trade and investment flows should not disguise the fact that the Washington establishment is committed to policies aimed at hobbling China’s economic development across the board (see China/US: Colombes ou Canards?).

The flash PMIs filled out the data calendar a bit and continued to trend down, reaching post-lockdown lows in much of the manufacturing sector while broadly undershooting expectations. Services activity levels are retreating into stagnation, with a risk that the decline extends into a slight recession. Labour markets still need to burn off excess demand. Monetary policymakers may privately welcome weakness as a step to achieving their inflation targets as further potential employment resilience still presents hawkish risks (see Activity Retreating Into Stagnation).

Central bank decisions this week broadly behaved like we expected, with Bank Indonesia on hold and the Fed and ECB hiking by 25bps with data-dependent guidance. The BOJ’s increased flexibility around yield curve control was the primary surprise, albeit not one that made much market impact on the day. It is arguably more about letting the market respond to news as it develops rather than trying to tighten monetary conditions now.

The ECB outcome was following through on its precommitment as policymakers looked beyond slower headline inflation to excessive underlying rates. Subsequent decisions will depend on the data as the ECB is “no longer in the domain of forward guidance”. We still expect slower underlying inflation and an ECB pause in September. A clear hawkish bias from the ECB and the Fed preserves space for BoE hikes beyond next week. Excessive wage deals worsen the UK’s state beyond its global peers (see Data-Dependent Inflation Hawks).

Next week’s flash EA HICP release is critical within this data-dependent framework. Releases from Germany, France, and Spain reduce the scope for surprise on the day, although Italy still poses risks. So far, national releases have skewed to the low side, with Spain the significant exception as it exceeded our above consensus forecast. Our estimate for the EA has fallen by a tenth in response to these releases, taking it to 5.3%, in line with the current consensus. Underlying inflation should continue trending towards target-consistent levels (see EA: HICP Decelerating Toward Target).

Figure 1: EA HICP inflation aggregates

Encouraging signs in the latest UK inflation release will not stop the BoE from hiking in August, despite June’s CPI inflation matching its forecast from the May Monetary Policy Report. Services inflation was still surprisingly strong because of excessive wage growth, which also surprised higher in the latest release. The BoE’s fumbled communications around its June hike placed spuriously high weight on those variables, perhaps because the political pressure couldn’t be stated without raising awkward questions about the Bank’s independence.

Market pricing is split between a 25bp and 50bp rate hike, and so is the consensus of economists, although the median is for the smaller increment. The outcome is exceptionally uncertain partly because the BoE failed to explain the logic around its return to forceful measures. We still lean towards another 50bp because of the second-round effects in wage growth, discouraging a dovish surprise. If the market were set on 25bp, the BoE would probably deliver that instead and extend the length of its hiking cycle if appropriate. The market tail is wagging the policy dog.

Fundamentally, we remain relatively concerned about wage settlements, which show no signs of breaking lower. So long as firms believe they can pass on the costs to consumers, they can raise their unit labour costs. The global debate about whether inflation can return to target while unemployment is so low ultimately transmits through wages. There is no doubt that 6% wage settlements are inconsistent with a sustainable return to 2% inflation amid persistently poor productivity. Public sector pay deals at this level or higher show an absence of restraint that justifies tighter policy to break the continuing drift up in wages.

The BoE’s decision on 3 August isn’t the only one on the agenda for next week, but it is the most prominent, partly because of the uncertainty. Another flurry of central bank announcements will come first, starting with Colombia on Monday, Thailand on Tuesday, and the RBA and Brazil on Wednesday. The consensus expects 25bp hikes from at least the RBA and BoT to 4.35% and 2.25%, respectively.

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