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Bank of England to Raise Rates to Combat Inflation

The decision today is either 0.25 or a 0.50 interest rate rise. Arguments can be made for both scenarios today. If the BOE raises by 0.25 this will be seen as not doing enough but expectations are for the rate rise cycle to continue till 2024. Raising the policy rate by 0.50 is more a credibility move for the BOE and would send a strong signal to the market that the BOE is serious. There are several factors that might sway things one way or another.

Housing Market Implications and Mortgage Payments

Mortgage applications in the UK are seasonally strong in Q2. Thus, the latest data is probably the strongest we will see and applications will likely fall in Q3 and Q4. About 10% of homeowners will face the risk of refinancing in the short-term so the overall effects on banks and repossession risk is somewhat mitigated. The number of howeowners on fixed rate mortgages is at a historic high of over 90% thus they will not feel the impact of rate hikes.

Demand for house sales has dropped already and prices have come down. The housing market is expected to fall by about 10% but that is not a crash. Unemployment needs to go up dramatically for a fall in house prices to hit crash territory.

Most banks have used a 7% or 8% stress test on prior mortgages, thus the majority of home loans already approved are fine based on the stress test holding other factors constant. Mortgage rates are expected to fall in 2024 based on falling inflation. Thus the risks to financial stability eminating from housing market should be contained.

If rates fall in 2024 to say 4% for mortgages, consumers should refinance to either short term fixed 2-year terms or variable if they need to refinance today. It should be noted that the UK mortgage market unlike the US mortgage market has fixed rate loans of 5 years and in some cases 10 years maximum. This makes it inherently more risky.

Monetary Policy Committee Considerations

According to Bloomberg, the expectation are for three members to vote hawkish, thus 0.5 rate rise. Four members are expected to vote 0.25 and one member to keep rates the same. Thus a 3:4:1 vote from the Bank or England Monetary Policy Committee (MPC). It should be noted that a dovish member recently left and Megan Greene who is hawkish too their place on the committee. The last three way spilt on a policy decision was last December. An important factor to consider for higher rates is that wage inflation is higher than core inflation and this could justify a 0.50 move.

Impact on Market and Economy

The UK economy is facing higher inflation rates compared to other developed economies. It has already had an impact on the economy and the medicine needed for the UK needs to be stronger thus expect the UK not experience the ‘soft landing’ scenario like the US. Obviously this will have an impact on UK stocks, but keep in mind that the UK index contains lots of cyclical companies (mining, banks) and is more of a barometer of the global economy compared to the UK. This is due to nature of the companies listed.

Our BOE Forecast on UK Interest Rates

Wage inflation is 7.9% and slowed recently but still above core inflation, thus we think this could prompt the BOE to raise by 0.5 at this time for credibility reasons. One concern was the effect on mortages and refinancing risk but mathematically this can be contained in our opinion. The risk is that the BOE goes too far and pushes the UK economy over the edge. Note that core inflation is still 6.9% with the latest data showing some weakness, but this is still high resulting in the need for interest rates to rise more in our view.

Our forecast is for 0.5 at this time with wording that further rate policy will depend on the data etc.  If it is 0.5 today then we expect only one more rate rise.

Our forecast is based on the need for the BOE to regain credibility, low risk to housing at the moment, and higher rates will dampen inflation expectations and move the UK closer to the inflation of other developed countries like the US and those in Europe.

Actual Decision:  rate decision was for 0.25 with recent weakening data playing a role.  Only two members voted for a 0.5 with Megan Greene voting for 0.25.  This decision will be criticized and we should expect more rate rises in the future.