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Bank of England maintains tightening bias

Thu, May 10 2007, 14:17 GMT
by KBC Market Research Desk

KBC Bank

• Bank of England raises rates by 25 basis points to 5.50%
• UK economy to maintain its steady growth pace
• Inflation to fall back to around 2% in the course of the year, …
• … but medium term inflation risks remain tilted to the upside
• Markets expect another rate hike to 5.75% this year. But aren’t they too confident?

At the May meeting, the Bank of England raised rates by 25 basis points to 5.50%, the highest level since spring 2001. The moved followed on the surprise spike higher in headline inflation to above the 3% level in March. In the statement, the Bank of England painted a picture of ongoing steady growth and limited spare capacity in the UK economy and as such concluded that the medium term risks remain tilted to the upside.

The statement was very similar to the January statement when the Bank of England last raised rates. There were however some slight differences.

While the MPC repeated that domestic demand has continued to grow steadily, they now made a distinction between business investment and consumer spending. According to the MPC, business investment has been stronger than expected, while consumer spending has been more volatile. The volatility in consumer spending may signal some uncertainty about the outlook for the UK economy going forward.

Regarding the inflation outlook, the MPC expects inflation to fall back to around the 2% target in the course of this year, as lower gas and electricity prices and weaker import price inflation work through. However, due to the limited spare capacity and the increased ability of businesses to push through price increases the medium term inflation risks remain tilted to the upside. This may signal an underlying tightening bias.

Currently, markets almost completely price in another rate hike after the May rate hike. However, given the outlook for inflation to fall back quite sharply in the coming months and the lagged impact of the recent increases in interest rates, we think markets are too confident in expecting another rate hike this year. Together with a further slowing of the US economy and euro zone economy over the peak, economic growth in the UK may slow more than currently expected refraining the MPC from raising rates further. The publication of the inflation report on May 16th and the Minutes on May 23rd will provide further insight in the current thinking of the MPC, while from an economic point of view, the inflation data will take central stage in the coming months.

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Published on  Thu, May 10 2007, 14:19 GMT