The Bank of England finds itself in a challenging situation as it approaches a crucial monetary policy decision in the midst of persistent inflation and a constrained labor market. Economists assert that the central bank is “caught between a rock and a hard place” as it weighs its options.

On Wednesday morning, the consumer price index for May will be released, just a day before the Bank’s Monetary Policy Committee (MPC) announces its next course of action on interest rates. Recent data indicates a sustained tightness in the labor market, robust underlying inflationary pressures, and a mixed yet surprisingly resilient growth momentum.

Consequently, economists now anticipate that the Bank will extend its tightening cycle and raise interest rates to a higher level than previously expected. This expectation has led to British 2-year government bond yields rising to a 15-year high of 5% in anticipation of a 25 basis point rate increase on Thursday.

Since November 2021, the Bank of England has implemented a series of rate hikes, increasing its base rate from 0.1% to 4.5%. Market indicators now suggest that it may ultimately reach 5.75%.

While headline CPI inflation in April decreased to 8.7% year-on-year from 10.1% in March, core CPI, which excludes volatile energy, food, alcohol, and tobacco prices, rose to 6.8% compared to the previous month’s 6.2%.

The Organization for Economic Cooperation and Development (OECD) recently projected that the UK would experience annual headline inflation of 6.9% this year, the highest among advanced economies.

Adding to the challenges faced by policymakers, labor market data from last week indicated stronger-than-expected results. Unemployment unexpectedly declined to 3.8%, and the inactivity rate also fell by 0.4 percentage points. Additionally, regular pay growth (excluding bonuses) in the three months leading up to April reached 7.2% compared to the previous year, surpassing consensus forecasts. The growth in regular private sector pay, a key metric for the Bank, rose to 7.6% year-on-year.

Regarding economic activity, May’s purchasing managers’ indices (PMIs) slightly moderated below expectations but remained in expansionary territory. Moreover, the UK’s gross domestic product experienced an unexpected 0.3% month-on-month contraction in March but partially rebounded with 0.2% growth in April.

Financial experts, including Goldman Sachs Chief European Economist Sven Jari Stehn, believe that although there is still some uncertainty surrounding the CPI release, the Bank of England faces a “high hurdle” in justifying a more significant increase of 50 basis points in its interest rate hikes. Stehn points out that inflation expectations remain stable, recent comments have shown no intention to accelerate the pace of rate hikes, and the upcoming meeting lacks a press conference or new projections.

Goldman Sachs expects the MPC to maintain its relatively accommodative stance due to resilient growth, persistent wage pressures, and elevated core inflation. They anticipate that stronger-than-expected data will push the Bank into implementing additional 25 basis point rate hikes, potentially reaching a terminal rate of 5.25% with risks tilted to the upside.

Similarly, BNP Paribas economists predict a 25 basis point rate increase on Thursday, considering that inflation expectations are lower than during the Bank’s previous 50 basis point hikes last year. They have also revised their terminal rate forecast to 5.5% in response to clear evidence of more persistent inflation.

Although the tightening cycle is expected to be protracted in order to tame inflation, BNP Paribas suggests that the MPC will exercise caution to avoid over-tightening. The Bank will closely monitor how the rate increases thus far impact households, particularly as fixed-rate mortgage renewals occur in the second and third quarters, given that rising borrowing costs are straining UK mortgage borrowers and affecting the availability of certain mortgage products.

Laith Khalaf, head of investment analysis at AJ Bell, states that the MPC is facing a difficult decision between pushing mortgage borrowers to the brink and allowing inflation to run unchecked. While current interest rate pricing reflects market concerns, a moderation of inflationary pressures over the summer would alleviate the situation. Khalaf adds that the Bank of England should consider that the full impact of its previous rate hikes is still working its way through the economy. However, if inflation remains high, both the Bank and the Treasury will face pressure to take action to ensure the Prime Minister’s commitment to halve inflation does not fall short.