Next month marks a decade since the Bank of England's Monetary Policy Committee (MPC) last raised UK interest rates. The July 2007 MPC meeting saw Bank Rate reach 5.75%: Figure 1. One week later Bear Stearns disclosed that two subprime hedge funds had lost nearly all of their value, symbolising for many the advent of the Global Financial Crisis.
This month's MPC saw the Bank of England's monetary policymakers surprise markets with a split 5-3 vote, with the three dissenters advocating an increase of 25 basis point in the bank rate to 0.5%. This move would have reversed the cut delivered by the Committee at their meeting last August. The scale of the split vote has raised the chances that the Bank of England will respond to above-target inflation – the UK's Consumer Price Index increased by 2.9% YoY in May – with a higher UK Bank Rate in the coming months.
In this post we consider the case for a change in UK monetary policy. We conclude that while a 25 basis point reversal and maintaining the current £435bn Gilt fund may be appropriate during the next two years, we see little evidence, at this stage, for the start of a rate cycle or a shrinkage in the BoE's balance sheet while Brexit-related political uncertainty and the global deflationary bias prevails.
In short, we continue to see UK Bank Rate at or below 0.5% until the end of the decade.
June's MPC meeting saw three* of the four external MPC members voting for an immediate increase in UK interest rates. It should be noted for the purpose of the next MPC meeting that is was effectively a 5-2 vote as it was the last with Kristin Forbes as an MPC member. In justifying their votes the three dissenters cited the faster than expected pick up in core inflation, Figure 2, and the expectation that “growth in business investment and net trade appeared on track to compensate for weaker consumption”**.
* Kristin Forbes, Michael Saunders, Ian McCafferty
** MPC minutes (June 2017): Paragraph 34
The remainder of the MPC, including the Bank’s Chief Economist Andy Haldane and the Governor Mark Carney, continue to see the current monetary policy stance as appropriate. We believe that there four major underpinnings to this view. Unaltered, we believe these factors will deter further MPC members for voting for higher Bank Rate.
- Global reflation is running out of steam: The UK is experiencing a pick up in core inflation: Figure 3 at the same time as the much-heralded global reflation stalls. This is further symbolised by the gradual flattening of global yield curves - as measured by the 10Y yield minus 2Y yield - since the end of Q1: Figure 4. Tax reform in the US economy and structural reform in the Eurozone will, in our view, be required to reverse this slowdown in growth momentum. For the UK, a price taker within a wide range of international markets, this return to a deflationary bias permits lower Bank Rate for longer.
2. Imported goods inflation. The decline in Sterling since the EU referendum triggered the pick-up in UK inflation - Figure 5 - has stabilised, and indeed partially reversed since the start of 2017. Thus far this import-intensive inflation has not spread to the more domestically-focused services sector: Figure 6. This is partly attributable to nominal pay growth trending down towards 2%. This lack of cost-push inflation triggering a wage spiral points to the transitory nature of the current round of UK inflation - and remains a mystery for central bankers around the world. The mystery favours a cautious approach to monetary policy normalisation.
3. Economic Activity and the “Broadbent Index”. The Deputy Governor for Monetary Policy, Ben Broadbent has previously pointed to the metrics he believes are most instructive for “calling” MPC voting patterns. He did this in his 2014 Jackson Hole speech*** . The “Broadbent Index” is a basket of domestic activity indicators that includes the UK PMIs and the CBI's industrial and retail survey data. While the index has rallied from its post-referendum low, it has not regained the levels achieved in late 2014 - Figure 7 - when the MPC were last on the verge of raising UK rates.
4. Market expectations for both inflation and the next change to UK rates remain subdued. Figure 8 shows that the SONIA market is still only pricing an increase in Bank Rate at a 36% likelihood by summer 2019. Figure 9 shows that index-linked gilt markets still see 5-year average CPI hovering around 2% suggesting that expectations remain well-anchored around the Bank's 2% target.
The economy, domestically and globally, may not evolve in the way that we, and the moderate core of the MPC, anticipate. Investors should remain alert to a volatile political backdrop that could change our thesis ahead of the August MPC meeting. We list four factors we recommend that investors should watch over the coming months to stay ahead of the UK interest rate story:
Factors to watch
- UK wages data: The real pay squeeze is set to fade in 2018 as inflation returns to target. The timing of this revival remains uncertain.
- MPC appointments: Two new MPC appointees are expected this summer. Their views and voting behaviour is a known unknown.
- Brexit negotiations: We do not expect swift clarity on future UK-EU trading arrangements, the passthrough to consumer sentiment is unclear at this stage.
- Fiscal policy: The recent General Election casts into question the government's tax and spending plans. A revised profile will be a key determinant for future inflation forecasts.