European Daily: BoE — How Different from the Fed?

■     The Bank of England’s cautious messaging at last week’s MPC meeting contrasts sharply with the Fed, which accelerated its tightening pace to 50bp increments. Given the many similarities between the UK and US economies, we explore whether the BoE’s macro backdrop is sufficiently different from the US to justify the divergence in messaging.

■     The main reason for the MPC’s caution is that the energy shock is about twice as large in the UK than the US, pointing to a sharper slowdown in UK consumer spending. That said, fiscal policy remains more growth supportive in the UK and financial conditions have tightened less than in the US. Our 2022 growth forecasts are thus similar for the UK and the US—slightly below trend and consensus, but significantly more upbeat than the BoE’s.

■     Moreover, underlying inflation pressures are remarkably similar across the Atlantic. The unemployment rate has fallen back to pre-covid levels, wage growth has risen to around 5% and core inflation has surged to about 6% in both economies. The US labour market shows stronger signs of overheating, but UK inflation expectations have moved up more.

■     While our analysis shows that the BoE faces a more difficult policy tradeoff than the FOMC, the MPC’s caution looks overdone compared with the Fed’s decisive tightening path. We therefore look for the BoE to hike to 2% with 25bp increments and start asset sales in the summer. But we see risks that the MPC might need to follow the FOMC in raising rates more notably if growth holds up better than expected.

The BoE delivered the widely expected 25bp hike last week, but sent a dovish message about the future path of policy. While the MPC remains concerned about upside risks to inflation (and three members voted for a 50bp hike), it sees the economy on the edge of recession (with some members preferring not to send any signal that further tightening is coming).

The BoE’s cautious messaging is thus in sharp contrast to the FOMC, which has accelerated its tightening pace to 50bp increments. Given the many similarities between the UK and US economies, we explore whether the BoE’s macro backdrop is sufficiently different from the US to justify the divergence in messaging.

A Bigger Energy Shock

The main reason for the BoE’s caution is the UK’s cost of living crisis. Exhibit 1 (left) shows that the energy shock is expected to be significantly larger in the UK than the US by year-end, with a contribution of energy to inflation that is roughly twice as large—at 4pp compared with 2pp—primarily because European gas prices have increased much more than in the US. As a result, we look for a peak of headline inflation of 9.5% in October, significantly higher and later than in the US.

We estimate that households hold roughly similar excess savings—11% and 12% of income in the UK and US, respectively—to help cushion the income hit. We therefore expect the surge in energy prices to weigh more heavily on household consumption growth in the UK than in the US, dropping below 1% next year (Exhibit 1, right) in Q4/Q4 terms.

That said, a number of other growth drivers still look more favourable in the UK than the US.First, our analysis suggests that fiscal policy remains growth supportive in the UK, in contrast to the sharp turn towards a drag in the US (Exhibit 2, left). In particular, we estimate a fiscal growth impulse of around +1pp in the UK this year, compared with a drag of more than 2pp in the US.

Second, financial conditions have tightened notably less in the UK (Exhibit 2, right). Our US financial conditions index (FCI) has now tightened by about 200bp since late last year, pointing to a notable growth drag in H2. UK financial conditions, however, have tightened by only around 50bp as the Pound has weakened despite the BoE’s hikes.

Taken together, our forecasts are similarly cautious in the UK and the US. In particular, we forecast growth of 1.4% in 2022Q4 (on a Q4/Q4 basis) in the UK and 1.5% in the US, both slightly below trend and a bit weaker than consensus. But our forecast for UK growth is significantly more upbeat than the BoE’s, which looks for only 0.7% growth over this period.

But Very Similar Price Pressures

Moreover, the outlook for the labour market and inflation is remarkably similar across the Atlantic.

First, both the UK and US economies have seen very rapid employment growth, resulting in tight labour markets (Exhibit 3, left). The unemployment rate has fallen back to about 4%, close to pre-covid levels and our estimate of the structural unemployment rate in both economies. That said, looking beyond the jobless rate—for example, to the jobs-workers gap—suggests that the US labour market has overheated more than in the UK.

Second, wage growth is very strong in both economies, reflecting labour market tightness (Exhibit 3, right). Our wage tracker—which summarises the main pay growth indicators—has climbed to around 5% across the Atlantic, sharply above the pre-covid pace. Looking ahead, our estimates suggest that wage growth will remain firm in both the UK and the US, running ahead of the rates that would be consistent with 2% inflation.

Third, underlying inflation pressures are running significantly ahead of target, with year-over-year core CPI inflation around 6% (Exhibit 4, left). While core inflation is likely to slow as the effect of goods bottlenecks diminishes, inflation is likely to remain significantly above 2% next year in both economies. Moreover, measures of long-term inflation expectations have moved up across the Atlantic, rising above average levels (Exhibit 4, right). However, the increase looks more pronounced in the UK, while forward rates of expectations—which discount near-term price expectations that are related to energy prices—remain more clearly anchored around 2% in the US.

All That Different?

The MPC’s caution on the growth outlook also suggests that it sees a markedly lower equilibrium interest rate (r*) than the FOMC, pointing to much less need to hike rates until policy returns to a more normal setting. Our analysis suggests that r* is probably somewhat lower in the UK (around 1.75%) than the FOMC’s estimate of 2.25-2.5%, leaving the latter with significant room for higher rates until policy reaches a neutral setting. That said, Bank Rate has historically been above the funds rate (except for the post-Brexit period) flagging that r* could be higher in the UK than our estimates suggest (Exhibit 5, left).

Running these estimates together with our forecasts for the economic outlook through a standard “Taylor rule” suggests that the MPC likely has less distance to travel in terms of rate hikes than the FOMC (Exhibit 5, right). But it also shows that the BoE still has significant amounts of tightening ahead in light of persistent inflationary pressures, pointing to upside risk to our forecast that Bank Rate will peak at 2%.

Taken together, our UK-US comparison supports the notion that the BoE faces a more difficult policy tradeoff than the FOMC, given a bigger slowdown in growth, similarly high inflation and a policy stance closer to neutral. But the MPC’s caution in our view looks overdone compared with the Fed given similarly persistent inflationary pressures and a number of remaining growth tailwinds.

We maintain our baseline that the MPC will continue to hike to 2% with 25bp increments and start asset sales in the summer. But we see risks that the MPC might ultimately need to follow the FOMC in raising rates more if growth holds up better than expected.