Bank of England rate cut – Seven years in the making

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For the past few years, the Bank of England’s MPC meetings have been pretty straightforward affairs, with the policy rate firmly on hold at its record low of 0.5%.

But the referendum result has dramatically changed the British political landscape and amplified the uncertainty over the near and long-term outlook for the UK economy.

A 25bp rate cut today is perhaps not quite the foregone conclusion which markets are almost fully pricing in. The BoE could today make valid arguments both to support a 25bp rate cut and no change.

On balance, however, I think the BoE has more compelling reasons to cut its policy rate 25bp today than to leave it on hold.

First, BoE Governor Carney has made clear that a rate cut was potentially on the cards, making it harder for him to backtrack.

Second, the British economy was showing clear signs of weakness even before the referendum.

Third, there are signs that economic and political uncertainty post referendum are already having a negative impact on consumption, investment and confidence.

Finally, the BoE may be the only game in town for now as there is limited room for domestic fiscal policy and global monetary policy reflation.

But cutting the policy rate to 25bp or even zero is clearly no panacea to the challenges which the UK faces in coming weeks, months and perhaps even years and there are valid counter-arguments as to why the BoE may leave its policy rate on hold today.

These include that the BoE should save its (limited) bullets and wait for more hard data, a BoE rate cut would set in motion self-fulfilling prophecy, the BoE should balance post-referendum chaos with a steady policy rate, the global equity market rebound has removed the sense of urgency and a rate cut could trigger uncontrolled Sterling depreciation.

Regardless of today’s decision, the BoE’s accompanying minutes will likely try to capture this new paradigm.

A rate cut today would still leave the BoE the option of cutting rates again at its 4th  August meeting but negative interest rate policy and/or quantitative easing are still likely to be measures of last resort.

BoE policy meeting once again under the microscope

The Bank of England’s Monetary Policy Council (MPC) concluded yesterday its scheduled policy meeting and will announce today at 12:00 (London time) its decision on whether to cut its policy rate. It will also simultaneously publish the minutes of its meeting.

The last time the MPC cut its policy rate was over seven years ago, in March 2009, when it halved rates to the current 50bp. Despite considerable changes to the UK and global economy in the ensuing period, markets have been pretty confident up till now that the BoE had few pressing reasons to change its policy rate. This is supported by the MPC members’ voting pattern. Since March 2009, there have been 86 policy meetings and 774 individual MPC votes. On only 29 occasions has an MPC member voted against the overwhelming consensus of no change. Of the current MPC members, Martin Wheale twelve times voted for a 25bp rate hike (the last time in December 2014) and Ian McCafferty eleven times voted for a hike (the last time in January 2016).

Had the British electorate voted on 23rd June for the UK stay in the European Union, today’s MPC announcement would have likely been another non-event, with markets instead focussing on the possibility of the US Federal Reserve hiking its policy rate at its meeting on 27th July.

But the referendum result has dramatically changed the British political landscape and amplified the uncertainty over the near and long-term outlook for the UK economy. The traditional rulebook for predicting the BoE’s policy rate path has been thrown out of the window (or at least shelved) and a 25bp rate cut at today’s MPC meeting is perhaps not quite the foregone conclusion which markets are almost fully pricing in. The BoE could make valid arguments both to support a rate cut and no change in the policy rate and regardless of today’s decision the BoE’s accompanying minutes will likely try to capture this new paradigm.

 

A probable rate cut today would be no panacea to multiple challenges facing the UK

On balance, I think that the BoE has more compelling reasons to cut its policy rate 25bp than to leave it on hold. This would leave the BoE the option of cutting rates again at its 4th August meeting when it will also publish new economic forecasts and will have a better sense of how the EU referendum result has affected the UK. If the BoE opts to leave rates on hold today – as two-thirds of economists expect according to a Reuters poll published on 5th July – I would expect the accompanying statement to at the very least leave the door wide open for a possible cut in August.

That is not to say that cutting the policy rate to 25bp or even zero is a panacea to the challenges which the UK faces in coming weeks, months and perhaps even years – it is anything but.

As I elaborated in Post referendum circular reference (7 July 2016), there are many layers of financial, economic, political, diplomatic, legal and constitutional uncertainty which will take time to peel back, even if Theresa May’s confirmed appointment as prime minister has removed one question mark. UK monetary policy can at best only mitigate some of this uncertainty. Put differently, cutting the policy rate 25bp may at the margin help small businesses, mortgage holders and confidence but it will do little or nothing to spur investment, spending or hiring on hold until the UK government clarifies its relationship with the EU.

The BoE of course could resort to more draconian options down the line, including negative interest rate policy (NIRP) and/or restarting its quantitative easing (QE) program. This would have been almost inconceivable a few months ago, but then again so would have the prospect of the UK leaving the EU. Nevertheless, I still think that NIRP and QE will be measures of last resort, which the BoE will only trigger if rate cuts fail to stabilise growth and the prospect of a clearer relationship with the EU fails to materialise.

 

I see four main reasons why the Bank of England will opt to cut rates:
  1. BoE Governor Carney clear that a rate cut is potentially on the cards, making it harder to backtrack
  2. British economy was showing signs of weakness even before the referendum
  3. Signs that economic and political uncertainty post referendum already having negative impact
  4. Limited room for domestic fiscal policy and global monetary policy reflation
Difficult for Carney to backtrack without denting BoE credibility

BoE Governor Carney seems to have taken the view that on balance some action is better than none, having already released up to £150bn worth of lending to households and businesses by relaxing regulatory requirements on the banking sector. Importantly he has made pretty clear in the wake of the referendum result that a rate cut could be on the cards. He stated on 30 June that “policy easing will likely be required over the summer” and on 12 July that “If the outlook has worsened, to use that term, in the judgement of the MPC there always could be monetary response if that is consistent with its remit”.

Whether he should have been more conspicuous is now neither here nor there. The cat is out of the bag, with the market now pricing in a 90% probability of a 25bp cut at today’s meeting. Carney has been criticised for flip-flopping on his views about UK monetary policy since his appointment as Governor in July 2013. Keeping rates on hold today could be interpreted as yet another u-turn and further dent the credibility of the BoE’s forward-guidance.

British economy was showing signs of weakness even before the referendum

Economic growth, investment and confidence weak in months running up to 23rd June

More fundamentally, as I wrote in EU Referendum survey results (18 May 2016), there are hard data which show that the UK economy was already soft before the referendum, as a result of domestic and foreign companies curtailing or delaying investment in the UK. Weak investment capped GDP growth at only 0.4% qoq in Q1 2016 (see Figure 1) and it’s not obvious that GDP growth was markedly stronger in Q2 (preliminary data will be released on 27 July).

Olivier Desbarres - BoE decision Fig1and2

  • UK gross fixed capital formation, seasonally-adjusted, increased only 0.5% quarter-on-quarter in Q1 despite a 1.1% contraction in Q4 2015 – the largest contraction in over three years (see Figure 2). Similarly, business investment shrunk a further 0.5% qoq in Q1 2016 following a 2% qoq contraction in Q4 2015 – the second and third largest quarterly contractions in six years which more than wiped out the growth in the previous two quarters (see Figure 2).

 

  • According to industry figures for June, new car registrations dropped in year-on-year (yoy) terms for only the second time in more than four years. The Society of Motor Manufacturers and Traders said that new car sales fell 0.8% yoy in June to 255,766.

 

  • Manufacturing output contracted 0.5% in May and was up only 1% between October 2015 and May 2016.

 

  • Unsurprisingly perhaps, business confidence remained depressed in the months leading up the referendum. The UK services PMI – arguably more important than its manufacturing equivalent as services account for about 75% of UK GDP – fell to 52.3 in June 2016 from 53.5 in May, matching April’s 38-month low (see Figure 3). The UK manufacturing PMI rebounded to 52.1 in June 2016 but remained below its two-year average of 52.6. Moreover, “almost all of the responses included in the final index readings were received prior to the end 23rd June referendum”, according to Markit.

Olivier Desbarres - BoE decision Fig3and4

Labour market was showing signs of cooling in the spring

In the three months to April, employment growth slowed to a 9-month low of 1.4% yoy while real weekly earnings growth dipped to a 13-month low of 1.6% yoy (see Figure 5). The share of full-time employees has also been stagnating around 73%. It would clearly be an exaggeration to qualify the UK labour market as weak, given an enviable unemployment rate of just 5%. But the labour market was cooling in the first four months of 2016 and generating little demand-pull inflation.

Olivier Desbarres - BoE decision Fig5and6

BoE likely to look through jump in imported inflation

Core CPI-inflation was stable at 1.2% yoy in May, with headline inflation stuck at 0.3% yoy – a long way from the BoE’s medium-term target of 2% (see Figure 6).

Of course the forward looking BoE will have concerns about imported inflation generated by the 27% increase in global commodity prices since January (according to IMF data) and more significantly sterling’s recent collapse. Analysts have forecast headline CPI-inflation surging to well above 2% in coming months. But the pass-through from higher international prices to domestic UK inflation will also be tempered by a likely downward adjustment in domestic consumption and imports.

Even prior to Sterling’s collapse in the wake of the referendum result, a weighted basket of Sterling’s exchange rates against the currencies of its main trading partners – its nominal effective exchange rate (NEER) – had weakened about 7% since mid-August (see Figures 7 and 8). And yet headline CPI-inflation only crept up very marginally from -0.1% yoy in September 2015 to 0.3% yoy in May 2016.

In any case, the BoE has shown its willingness to look past spikes in inflation deemed temporary, as evidenced by its decision to keep rates on hold despite headline CPI-inflation spiking above 5% yoy in September 2011 (see Figure 6).

Olivier Desbarres - BoE decision Fig7and8

Trade and current account deficits justify weaker Sterling

While a weaker Sterling may add to imported inflation, improved currency competitiveness is also more positively helping the UK narrow its still high trade deficit and temper a current account deficit of 6.9% of GDP in Q1 2016 – only marginally lower than the record high deficit of 7.2% of GDP in Q4 2015.

Olivier Desbarres - BoE decision Fig9and10

A more competitive currency likely contributed to a pick-up in UK exports of goods and services in March-May 2016 (see Figure 9) and a narrowing of the trade deficit (see Figure 10). But the very existence of a trade and current account deficit suggests that Sterling may have still been over-valued. So while the BoE may not have an optimum exchange rate level in mind, Sterling is today arguably closer to its fair value based on balance of payments fundamentals, particularly if post-referendum uncertainty tempers the demand for UK exports.

 

Post referendum uncertainty already making itself felt  

The net impact of the referendum on the British economy cannot yet be quantified with any degree of certainty. The first unofficial data for July (e.g. PMI) are only due for release on 1 August, while the first official data for July will not be available for another couple of months. In any case it will be many months before policy-makers can estimate more precisely this impact – and it will remain at best an estimate as factors beyond the referendum will continue to influence UK economic variables.

However, there is anecdotal evidence that the impact on the UK economy has been and will continue to be negative in coming months.

  • Consumer confidence collapsed to -9 in a survey which Gfk conducted between 30th June and 5th July from -1 before the referendum, well below its two-year average of +1.2 and the highs reached after last May’s general elections (see Figure 4). The YouGov/Cebr Consumer Confidence Index, which measures people’s economic sentiment on a daily basis, stood at 111.9 in the first three weeks of June but since the referendum has slumped to 104.3 – wiping out the gains made over the last three years.

 

  • The number of people visiting British shops fell 3.4% yoy in the 10 days following the referendum, according to retail data company Springboard.

 

  • The YouGov/Cebr Business Confidence Index fell from 112.6 on 21-23 June to 105.0 on 28 June-1 July and the share of businesses that are pessimistic about the economic outlook over the next 12 months doubled from 25% to 49% in the course of a week.

 

  • A number of large, UK-based, domestic and foreign companies have publicly stated in recent weeks that they had already activated contingency plans to move some operations abroad and frozen domestic investment and hiring plans. UK exporters are already facing a more uncertain trading environment with the EU at a time of weak global demand.

Foreign direct investment into the UK is also likely to fall further until there is greater UK policy certainty although this does not preclude tactical investments by foreigners attracted by a cheaper Sterling.

The bottom line is that the longer this political, legal and economic uncertainty prevails, the greater the likely damage to the UK economy. Beyond the effects of Brexit, the government still needs to address the residual problem of low productivity and wage growth and still-high levels of household debt.

 

Bank of England – Only game in town?

The BoE will also be aware that it may be the only game in town. There is limited room for domestic fiscal policy reflation as the Treasury, which remains for now committed to fiscal prudence, is likely to be hampered by weaker economic activity and lower fiscal revenues. This assessment admittedly remains tentative given Chancellor Osborne’s recent dismissal.

Moreover, unlike 2008-2009, UK policy-makers cannot rely on global and coordinated policy rate cuts and quantitative easing measures to boost global GDP growth (at a multi-year low of 2.8% yoy in Q1) and in turn domestic growth. Indeed central bank policy rates are already at record lows in Sweden (-0.5%), Japan (-0.1%), Denmark (0%), the Eurozone (0.05%), Norway (0.5%), Australia (2.0%) and New Zealand (2.25%) and near record lows in the US (0.375%) and Canada (0.5%). In this global context, a 25bp BoE rate cut to 0.25% would not look out of place.

 

Counter-arguments to rate cut have some merit

A number of counter-arguments have been put forward as to why the BoE will leave its policy rate on hold today. Most have merit but only to an extent, in my view.

 

BoE should save its (limited) bullets and wait for more hard data

The BoE could indeed wait a couple of months for hard data to confirm that UK economic growth has indeed slowed before pulling the trigger. If we assume that the BoE is reluctant to take the policy rate into negative territory – due to adverse effects on the banking sector – it will want to get the most bang from potentially only two 25bp rate cuts. But the BoE would be taking the risk that if official data indeed confirm a slowdown in UK growth, it will have to cut more aggressively than it would have had to in order to achieve the same result.

 

BoE rate cut would set in motion self-fulfilling prophecy

One argument which has gained traction in recent weeks is that the collapse in sterling and early signs of some damage to the economy are the product of scare-mongering amongst policy-makers, not of the referendum result itself. But markets, companies and consumer are arguably reacting rationally to the uncertainty about when and how the UK will exit the UK. Importantly, this uncertainty is unlikely to lift any time soon, weakening the argument that the BoE would be wrongly reacting to an ephemeral event.

 

BoE should balance post-referendum chaos with steady policy rate

Andrew Sentance, a former MPC member, has argued that BoE Governor Carney should provide stability by keeping rates on hold today. But that ignores the fact that the market is already pricing in 23bp of cuts today. Carney could have arguably opted to say little or nothing in the wake of the referendum so as to keep his options open and keep the market guessing. But that ship has sailed. Going against market pricing at today’s meeting would arguably create more uncertainty in financial markets, not less.

 

Global equity market rebound has removed sense of urgency

The recent rebound in global equities, including the FTSE-100, may have eased concerns that the BoE cannot afford to wait. The MSCI all-country World Equity Index is now back to its pre-referendum level and the FTSE-100 is up about 5%.

But the FTSE-100 has arguably rebounded because it is mainly composed of international companies which benefit from Sterling’s collapse and boost to the Sterling-value of their foreign earnings, rather than because of an underlying improvement in corporate fundamentals. It is noteworthy that the FTSE-250, which is composed mainly of UK companies, is still down 3.4% since 23rd June.

 

Rate cut could trigger uncontrolled Sterling depreciation

With the Sterling NEER already down 10% since 23rd June, there may be some concern that a rate cut would increase the risk of further unbridled currency depreciation. However, despite the probability priced in by the market for a full 25bp cut having steadily increased, the Sterling NEER has actually appreciated 2% since 7 July. Unless the BoE takes the unlikely step of cutting 50bp today, a rate cut is unlikely to significantly weaken Sterling, in my view.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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