BoE Expected to Hike Rates in November as Energy Shock Pushes UK Inflation Above 4%, MUFG Projects

What happened

The Bank of England (BoE) is expected to raise its key interest rate by 25 basis points at its November 5 meeting, with a further hike in February, taking the rate to a peak of 4.25%. This is according to MUFG's projection, which points to the energy shock as the primary factor, pushing UK inflation above 4% in the coming months. Energy prices have remained elevated longer than anticipated and have risen further recently, impacting household bills. The UK economy has shown resilience, with activity data consistently surprising to the upside and Q3 GDP tracking at about 0.65% quarter-on-quarter growth. The labor market is stabilizing, growth is healthy, and underlying inflation remains elevated, with services inflation well above the BoE's 2% target. MUFG forecasts growth of 1.5% in 2026 and 1.4% in 2027, surpassing IMF projections.

Why it matters

The expectation of additional monetary tightening by the BoE is crucial for the UK's economic policy. Persistent inflation, especially that driven by energy costs, compels the central bank to act, even against a backdrop of higher borrowing costs that have already reduced the government's fiscal headroom to around £15 billion ahead of the Budget. The economy's strength, despite energy-related headwinds, gives the BoE less room to 'look through' the inflationary shock. The UK's comparatively rapid adoption of artificial intelligence is cited as a possible factor behind recent productivity gains, which could sustain growth but also maintain inflationary pressure in some sectors.

Market impact

• Interest rates and bonds: Gilts (UK government bonds) are seen as the more vulnerable asset. 10-year UK yields already sit at the top of the G7 range. Further monetary tightening alongside reduced fiscal headroom ahead of the Budget could keep pressure on longer-dated debt, leading to an increase in yields.
• Dollar and FX: Sterling (GBP) tends to be supported by a rate hike, particularly against currencies where central banks are perceived as slower to respond to inflation. A longer hiking cycle, if energy prices continue to rise, would further strengthen the pound.
• Equities: Higher interest rates and elevated energy costs weigh on domestically focused UK stocks. However, the FTSE 100, which has a strong representation of energy companies, may offer some offset as these constituents benefit from higher energy prices.
• Commodities: Oil and gas remain a key swing factor. Any further spike in prices, especially linked to the Middle East war, would strengthen the case for a longer hiking cycle, given that household energy bills are driving the expected rise in inflation.
• Brazil: Indirectly, monetary tightening in the UK contributes to a global scenario of higher interest rates, which can increase risk aversion and put pressure on emerging market currencies like the real, as well as impact capital flows to markets such as Brazil.

What to watch

Upcoming UK inflation and labor market data will be crucial to confirm or invalidate the BoE's tightening expectations. The BoE's monetary policy decision on November 5 will be the most immediate event to watch, with particular attention to communication and any forward guidance on future hikes. The UK Budget will also be important for assessing the government's fiscal response to higher borrowing costs and support for households.

Scenarios

Base scenario: The BoE hikes rates in November and again in February, reaching 4.25%, with the economy showing resilience but inflation remaining elevated due to energy costs. Sterling strengthens, and gilt yields rise. Risk scenario: A sharper-than-expected economic slowdown or a significant drop in energy prices could lead the BoE to adopt a less aggressive stance, easing pressure on gilts and potentially weakening sterling. Conversely, an escalation of the energy crisis or the Middle East war could force an even longer hiking cycle.

Original source: ForexLive (InvestingLive). For information only, not investment advice.