Uk Monetary Tightening Continues - Responding To Higher-than Expected Inflation

9th February 2022

A report by DBRS Mornngstar.

Key Highlights
• DBRS Morningstar views the BoE's monetary tightening in response to higher-than-expected inflation as in line with its mandate, trying to rein in inflation expectations.
• After increasing interest rates from low levels twice already since December 2021, the BoE is expected to rise interest rates further in 2022.
• UK inflation is yet to peak, forecast at over 7% in April 2022, largely reflecting high energy prices, while the labour market remains tight.
• Although UK government debt is now more sensitive to rises in interest rates than in the past, we expect higher interest payments to remain low and the overall debt profile to remain favourable.

The Bank of England (BoE) has raised its policy rate for a second consecutive time, in response to high and rising inflation in the UK. In line with the BoE's signal on the policy path, DBRS Morningstar expects further increases in Bank Rate this year, as inflation is yet to peak and labour markets are tight. In this commentary, we take a look at the monetary policy response to higher consumer prices in the UK, the inflation outlook and some of the credit implications of monetary tightening for the UK government debt.

The BoE's Second Rate Hike, With More Increases to Come This Year
At its latest policy meeting at the beginning of February, the BoE's Monetary Policy Committee (MPC) increased Bank Rate by 25 basis points to 0.5%. This follows the first rate hike since March 2020, from 0.10% to 0.25% in December 2021.

Quantitative tightening is also set to begin. The MPC voted to start reducing the stock of UK government and corporate bonds, by ending the reinvestment as bonds mature. The BoE will also sell the stock of corporate bonds on its balance sheet through a programme to be completed by the end of 2023.



More monetary tightening is on its way. The BoE has signalled that further rises in Bank Rate are highly likely, given the updated outlook for inflation. Some members of the MPC voted during last week's meeting to increase Bank Rate by 50 basis points to 0.75% rather than to 0.5%. With the increase in Bank Rate, the BoE is trying to return the inflation rate to its target of 2%. The BoE is projecting inflation to slow to just above the 2% target in two years' time and to below the target by a larger margin by Q1 2025. We view the BoE's policy response to higher-than-expected inflation as in line with its mandate of price stability, as it tries to rein in inflation expectations.

Inflation Higher For Longer But Expected to Slow Over Time
The UK's inflation rate has been above the BoE's target since May 2021 and has risen faster than expected in recent months. In December 2021, the annual inflation rate reached 5.4%, the highest in almost 30 years. Core inflation has also increased significantly, reaching 4.3% in December 2021.

The rise in inflation in recent months has been driven to a large extent by energy prices (Exhibit 1). Petrol prices have increased by around 30% and electricity prices by close to 22%. This was after the energy regulator, the Office of Gas and Electricity Markets (Ofgem) increased the energy price cap by 12% in October 2021, as a result of higher wholesale natural gas prices. The rise in inflation also reflects a combination of domestic and external factors, including global supply-chain

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