Bank of England – Trick rather than treat

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The Bank of England (BoE) hiked rates 25bp yesterday for the first time in a decade, as expected, with recent domestic and global macro data seemingly helping the Monetary Policy Council inch over the rate-hiking start line.

But that was not the real story, with financial markets always likely to look beyond the headline decision and focus instead on the underlying message.

Markets’ dovish reaction in the past 24 hours suggests that they zeroed in on BoE Governor Carney’s view that future rate hikes would be gradual and limited.

The Sterling Nominal Effective Exchange Rate is down 1.4% to the bottom of a 5-week range and markets are now pricing only a 34% probability of a 25bp hike in February.

Carney’s cautious outlook for the policy rate’s path is in line with my expectations that macro data and the cloak of uncertainty which surrounds Brexit will limit the need and room for the BoE to tighten monetary policy.

Fundamentally, the UK economy remains fragile, with lacklustre GDP growth of only 1% in Q1-Q3 2017 lagging growth in other G7 economies, and the medium-term outlook remains uncertain at best, in my view.

Weak retail sales and household consumption growth of only 0.5% in H1 is clearly acting as a drag on overall economic growth.

A key reason is that growth in economy-wide real earnings has slowed sharply in the past two years, in turn the by-product of slowing growth in employment and real earnings.

Moreover, the household savings rate is an already very low 6% while commercial banks are looking to tighten lending standards and pass on yesterday’s rate hike to borrowers.

With this backdrop and likely slowdown in imported inflation, core and headline CPI-inflation may be close to peaking, in my view, although there is of course the no small-matter of Brexit, a known unknown of considerable magnitude.

Governor Carney’s clear message that the BoE may not need to hike much to get inflation back down to 2% in coming years is somewhat reminiscent of the US Federal Reserve’s policy stance in 2015 and 2016.

It is possible, in my view, that the BoE’s rate hiking cycle could mirror the Fed’s with the BoE only delivering one (or perhaps two) hikes in 2018, in which case markets may need to further reduce their expectations of a February 2018 rate hike.

 

Bank of England hikes rates for first time in a decade but that was not the real story

The decision by the Monetary Policy Council (MPC) of the Bank of England (BoE) to hike its policy rate 25bp to 0.5% at its policy meeting yesterday is grabbing the headlines, perhaps understandably given that the MPC last hiked rates on 5th July 2007 (3,773 days ago) to a now almost unbelievable 5.75%. Gordon Brown had just been appointed leader of the Labour Party and Prime Minister, George W Bush was still in charge of the White House and Rihanna (featuring Jay-z) topped the charts with Umbrella.

However, the MPC’s decision to double the policy rate had been well telegraphed in the past couple of months and almost fully priced in by interest rate markets. The MPC had made clear at its September policy meeting and in subsequent comments that it was keen to reverse an August 2016 rate cut mainly triggered by acute concerns, partly unwarranted with the benefit of hindsight, about the impact of the referendum Leave vote on the British economy.

I acknowledge that I had, earlier this year, under-estimated MPC members’ willingness (and they would argue room) to hike rates this year, with my core view having been that the MPC would not pull the trigger until 2018 (see No UK rate hikes this year and room for further Euro upside, 28 July 2017). Ultimately, recent domestic macro data, while unspectacular, and the sustained pick-up in global GDP growth helped the MPC inch over the rate-hiking start line, as I summarise in Figure 1.

 

olivier desbarres trick treat fig 1

 

Markets have seemingly focused on dovish elements of Carney’s message

However, financial markets were always going to look beyond the headline decision and focus instead on:

  • The accompanying policy statement;
  • The MPC members’ voting pattern;
  • The BoE’s underlying macro assumptions and forecasts; and
  • Governor Mark Carney’s post-meeting Opening Remarks and Press Conference

Markets’ dovish reaction in the past 24 hours suggests that they took note of the accompanying statement, which unlike the September statement dropped the reference to “monetary policy could need to be tightened by a somewhat greater extent over the forecast period than current market expectations”. Much has also seemingly been made of the assumption, contained in the Inflation Report and Carney’s Opening Remarks, that current market yields, which are used to condition the BoE’s forecasts, incorporate two further 25bp hikes over the next three years. However, I would note that is only a market-based assumption and it differs little from the one contained in the August inflation report (approximately 40bps of hikes by end-2019)

The real focus seems to have been on Carney’s unambiguous message in his Opening Remarks and Press Conference that future rate hikes would be very gradual and limited. Conversely, hawks appear to have taken little comfort from the BoE’s overall constructive tone or the fact that seven out of nine MPC members, including Governor Carney, voted for a rate hike (there had been talk in the press of a possible 6 vs 3 or even 5 vs 4 decision).

 

  • The Sterling Nominal Effective Exchange Rate (NEER) is down 1.4% to the bottom of a five-week range (see Figure 2).

 

  • Markets are now pricing in only 8.5bp of hikes at the February policy meeting (or a 34% probability of a 25bp hike), versus a 50% probability priced in before yesterday’s meeting.

 

  • While 2-year government bond yields jumped 21bp (to factor in the 25bp rate hike), 5-year government bond yields were broadly unchanged, causing the 2s5s yield curve to further bear flatten (see Figure 3).

 

olivier desbarres trick treat fig 2 and 3

 

Carney’s cautious outlook for the policy rate’s path is in line with my expectations that macro data and the cloak of uncertainty which surrounds Brexit will limit the need and room for the BoE to tighten monetary policy (see Olivier Desbarres: global growth and central bank outlook, 20 October 2017).

Fundamentally, the UK economy remains fragile, with lacklustre GDP growth of only 1% in Q1-Q3 2017 lagging growth in other G7 economies, and the medium-term outlook remains uncertain at best in my view. The drivers of growth are numerous and often inter-related (see Figure 4).

 

 

But weak household consumption growth of only 0.5% in H1 is clearly acting as a drag, as per Figure 5 (Q3 data will be released with the second estimate of GDP on 23 November 2017). Growth in retail sales, a key component of household consumption, of only 0.6% qoq in Q3 points to modest growth in the broader measure of household consumption (see Figure 6).

 

olivier desbarres trick treat fig 5 and 6

 

A key reason behind these trends is that growth in economy-wide real earnings has slowed sharply in the past two years (see Figure 7), which is in turn the by-product of employment growth having slowed to around 1.1% year-on-year in June-August from 1.9% yoy a year ago and real earnings falling 0.3% yoy (see Figure 8). I would attribute nominal wages struggling to keep up with rising inflation to a number of structural and cyclical factors which are largely out of the BoE’s sphere of influence, including:

  1. The glacial pace of growth in output-per-worker of about 0.4% in the past year, which has resulted in the level of labour productivity having effectively stagnated since end-2014;
  2. A still large (albeit declining) pool of 12 million workers who are either unemployed (1.44 million), working part-time (8.55 million) or not actively seeking a job but available to work (2 million); and
  3. A still widespread public-sector pay freeze.

 

 

With the household savings rate an already very low 6%, consumers have partly had to rely on banking lending. But commercial banks are looking to tighten lending standards and have already signalled that they wills pass on yesterday’s 25bp rate hike to holders of unsecured loans and floating mortgages. Higher borrowing and repayment costs will in turn likely have a negative impact, even if modest, on consumer spending and business investment.

Admittedly a weak Sterling is encouraging British consumers to vacation at home (“staycations”) and inward tourism which is a boon for the retail sector, but this is only a partial counter-balance to the weakness of real wages and likely headwinds to consumer borrowing.

 

CPI-inflation – A modest peak?

With this backdrop it is difficult to envisage a brisk recovery in wage inflation, consumer demand and GDP growth, which in turn is likely to cap the rise in domestically-generated inflationary pressures. Combined with a likely slowdown in imported inflation, core and headline CPI-inflation, which rose to respectively 2.7% yoy and 3.0% yoy in September, may be close to peaking, in my view. The BoE forecasts only a modest rise in October.

Even if assume that Sterling’s depreciation of the past 24 hours is not reversed, Sterling’s relative stability in the past year implies that the year-on-change in the NEER would remain near zero in coming months, according to my calculations. Precedent suggests that this is likely to drag down imported inflation, which was still 5.1% yoy in August, even if we account for the rise in commodity prices since mid-year, including for crude oil prices which are up about 15% yoy (see Figure 9). The MPC shared this view in yesterday’s policy statement.

 

 

If domestic inflation remains subdued and imported inflation falls in coming months, history points to a fall in both headline and core CPI-inflation (see Figure 10).

 

olivier desbarres trick treat fig 10

This would tie in with Mark Carney’s view that the BoE may not need to hike much in coming years to get headline CPI-inflation back toward its 2% target. There is of course the no small-matter of Brexit, a known unknown of considerable magnitude and the BoE has in the past had to revise its estimates of how the UK’s pending departure from the EU in sixteen months is impacting the British economy. But unless the pace of negotiations between Prime Minister May’s government and its EU counterparts picks up, I remain of the view that Brexit-related uncertainty will continue to dampen rather than underpin UK economic growth whether or not the Sterling NEER remains in the 7%-wide range in place since last autumn.

Bank of England mirroring its cousin across the pond?

Governor Carney’s clear message of a very slow and gradual rate hiking process is somewhat reminiscent of the US Federal Reserve’s policy stance in 2015 and 2016.

In the wake of its first rate hike in December 2015, Janet Yellen and the FOMC were keen to emphasise that the tightening cycle would be very modest and indeed the Fed hiked again only twelve months later, in December 2016. And while the Fed had to contend with still modest US inflation and volatile GDP growth, unlike the BoE it did not have the Damocles Sword of Brexit having over its head (and policy decisions). It is only this year that the Fed has stepped up its hiking cycle, with two 25bp rate hikes already in the bag and a third hike in December 2017 increasingly looking like a near certainty.

 

 

It is possible, in my view, that the BoE’s rate hiking cycle could mirror the Fed’s with the BoE only delivering one (or perhaps two) hikes in 2018 and only hiking at a faster pace well after it has assessed the impact of the UK’s exit (assuming it goes ahead) in March 2019. In this case markets may need to further reduce their expectations of a February 2018 rate hike.

After all, BoE monetary policy has often mimicked the Fed’s decisions on interest rates and quantitative easing in the past decade, as summarised in Figure 11. The BoE started both its hiking cycle and quantitative easing (QE) program four months after the Fed. While it stopped QE two-and-a-half years after the Fed, it is conceivable that it would have started hiking rates not long after the Fed had the British electorate voted Remain in the June 2016 referendum on EU membership.

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