ECB holds course but BoE in trouble

European Central Bank

The recent series of interest rate hikes has highlighted the ECB's sluggish response to inflation. Consequently, the Bank revised its inflation projections upward, citing a robust labour market and potential unforeseen developments in the near future. President Christine Lagarde emphasized the Bank's commitment to exert maximum effort to return inflation to its 2.00% target. This objective is expected to be supported by elevated borrowing costs and stricter financing conditions within the broader market.

There was no explicit commitment to further hikes at future meetings with Lagarde setting out a plan to bring rates to a level “sufficiently restrictive to achieve a timely return of inflation to our 2.00% medium term target and will be kept at these levels for as long as necessary”. With inflation still running at 6.10% in the Euro area and the labour market still tight, a return to looser monetary policy in the near future is looking increasingly unlikely.

The markets are still pricing in at least one further hike from the ECB before the current cycle of tightening comes to an end, and several economists are forecasting hikes in both July and September. The Bank is taking a leaf out of the BoE book by pledging that future decisions will be “data dependent” and contingent on how the current measures affect market dynamics in the next few weeks.

Bank of England

It has been a tumultuous week in the U.K. markets and the BoE have found themselves under fire from several angles. The first and most problematic was the lack of change from April in the annual inflation figures which remained stubbornly high at 8.70%, beating economist expectations. Core inflation rose from 6.80% in April to 7.10% in May, the highest level since 1992. This has set alarm bells ringing in the corridors of power as it put the U.K. out of step with its G7 counterparts who are seeing inflation fall back to more “normal” levels much faster.

The GBP 5-year swap rate rallied 16 basis points off the back of the inflation figures before settling back later in the day. Following the announcement of the 50 basis points hike from the BoE, the five-year rate fell 5 basis points, suggesting market participants had already priced in this move despite the narrative around its “unexpected” nature. Current projections anticipate four further hikes by December 2023 with an anticipated terminal rate of over 6.00%.

Commentary from ex-BoE governor Mark Carney suggested that Brexit could be a significant contributing factor to the disconnect between U.K. predicament and that of its peers. Speaking to the Daily Telegraph, he stated that “[the BoE] laid out in advance of Brexit that this will be a negative supply shock for a period of time and the consequence of that will be a weaker pound, higher inflation and weaker growth.” A combination of a reduction in the number of immigrant workers - resulting in wage inflation - along with the outsize food inflation shock - because of the new border situation with the E.U. - have both contributed to the U.K.’s current predicament.

We are starting to see a meaningful divergence in the rates and inflation outlook between the E.U., U.S. and U.K. The Federal Reserve paused hikes at its latest meeting, while the ECB held course and the U.K. was forced to accelerate the pace of its rises. The repercussions in the real economies of each country and the impact on their respective currencies going forward remains to be seen but could be significant in disrupting the status quo.