Policymakers Keep Their Focus

• Over the past week, financial stability concerns crushed market pricing in a panic before stabilising. The ECB kept its focus on high inflation and delivered its 50bp rate hike, while hawkish pressures built further in the UK labour market and budget.
• Next week provides an opportunity for the BoE to respond, and we still expect it to hike by 25bp after the Fed does the same, despite CPI inflation slowing to 9.8% (0.1pp under the BoE forecast). We will also watch the flash PMIs after recent resilience.

Massive market moves have made it an exciting week across the policymaking spectrum. The financial stability side was in the hot seat, supported by politicians, leaving monetary policy to focus on the inflation problem. Nor was news only about the short term. President Joe Biden’s budget proposals confirmed that he is already campaigning for a second term even though, like Ron DeSantis, he has not formally declared yet (see US: Undeclared, But On The Trail).

The UK government will at least implement its budget. It cancelled energy price hikes, as expected, then reformed investment and pension allowances. Fiscal space is used between 2024 and 2026 but preserved beyond that for a pre-election giveaway by pretending some policies are temporary. However, space may not exist outside of the OBR’s imagination. Sustained brisk potential growth creates excess supply in the OBR view of 1Q23. Without that, GDP and revenues will underperform, further prolonging high debt issuance (see UK: Imagining Spurious Fiscal Space).

A bumper offer to the NHS’s over one million workers will also worsen the inflation problem. 5% has become a floor for 2023-24, with some getting more than 10%, while 2022-23 gets 4pp and a bonus worth another 3.5-8.2%. Throwing more money at underperformers makes the BoE’s job harder.

More generally, pay settlements continue drifting higher, with over 70% exceeding 4% in January and signs of anchoring around 5%. Ongoing resilience amid high vacancies indicates unemployment may resist rising in Q1, extending cyclical excesses. Such pressures remain far too high. Silicon Valley Bank’s smooth failure is unlikely to break them, so the BoE still has more work to do, with another two 25bp rate hikes in our view (see UK: Data Issue Hawkish Reminder).

The ECB delivered another 50bps rate hike, as promised in February and expected. It is not allowing Silicon Valley Bank’s broadly irrelevant failure to break its focus. Higher core inflation forecasts extend the problem and necessitate a tight monetary setting to break excessive pressures. ECB policy is rightly calibrating to fit the data. We forecast 25bp deposit rate hikes in May and June, with risks skewed towards further steps if resilience outlives the current financial stability issues (see ECB: Delivering the Required Hikes).

Reminders of those inflationary issues were in the final EA print’s slight slowing to 8.5% in Feb-23. The ex-tobacco rate hit 8.61%, only 2bps above our forecast amid marginal news in the details. Resilience was also confirmed in the core measures, which do not appear to be converging towards target-consistent rates. Excesses haven’t broken yet. Although March may undershoot the consensus amid less seasonal space to rebound from January, we see inflation trending above the ECB’s forecast, encouraging more rate hikes (see EA: HICP Resilience Confirmed in Feb-23).

Preview: UK inflation in Feb-23

The downside surprise in Jan-23 provided a misleading impression of inflationary trends in the UK. A spuriously overweighted seasonal decline in airfares caused it, but those weights are already broadly reversed, as we warned (see UK: New Weights Stoke CPI Seasonality). The artificial negative effect will not be revised away but should be recognised as noise rather than signal.

Under the updated weights published last week, inflation should slow much less this month. Like the consensus, we expect CPI inflation at 9.8% in Feb-23 amid slower transport and recreation price inflation than last year. Falling petrol and second-hand car prices explain the former, while the latter comes from a return to the usual seasonal pattern in game prices, which resumed in January. Games prices affect the RPI less, but mortgage rate hikes also boost it. So we are slightly above consensus in forecasting the RPI rounding to 13.3%, down from 13.41%.

Figure 1: Contributions to m-o-m UK CPI inflation

Preview: BoE +25bps

The Bank of England has struggled to communicate its reaction function again recently, albeit not helped by optimal policy’s temporal inconsistency during second-round effects. It can’t respond dovishly to low inflation forecasts lest expectations are encouraged to stay excessively high, negating that path materialising. Unfortunately, the BoE hasn’t managed to break those excessive expectations yet, so the hawkish problem persists (see UK: Hawkish Tide Not Turning Yet).

Financial stability risks are unlikely to deter the BoE from its task. Something needed to happen to Silicon Valley Bank’s UK arm, but it was irrelevant outside of some US scale-ups operating in the UK. So, there should be no significant confidence shock, especially as the failure was smoothly resolved. Other policy manoeuvres compound the hawkish pressures with a little fiscal stimulus and a generous pay deal to the NHS that further feeds second-round effects.

We expect the BoE to hike by 25bps on 23 March, with the same two dissents for no change. Guidance will likely be non-committal to the following steps, as they will depend on how the inflation outlook evolves. Two-way optionality does not negate our forecast for a May hike.

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