Simon French, Chief Economist
Simon French is the Chief Economist at Panmure Gordon. Prior to joining Panmure he worked for the UK Government, latterly at the Cabinet Office as Chief of Staff to the UK Government COO.
He had a central role in implementing the Coalition Government’s spending reforms between 2010 and 2014 as well as working on the Governments Welfare and Pensions reforms between 2002 and 2008.He holds an Undergraduate and Postgraduate degree in Economics and Finance from Durham University.
It was July 2007 when the Bank of England last raised UK interest rates. Rihanna was top of the UK charts and Northern Rock was a FTSE100 company. 3,772 days later and it is widely expected that the Bank will reverse last August’s post-Referendum 25bp interest rate cut when policymakers meet later this week. However nothing is a foregone conclusion. We have been here before – in June 2014 at the Governor’s Mansion House speech – and then again at his July 2015 speech in Lincoln. On both occasions markets were primed for higher interest rates only for UK inflation to subsequently disappoint and the Monetary Policy Committee (MPC) to leave UK Bank rate unchanged.
What should financial markets expect on Thursday?
Since the release of the September MPC minutes market participants have been guided by UK ratesetters to expect a near term 25bp increase in Bank rate. In the words of the Committee:
“[a] withdrawal of monetary stimulus is likely to be appropriate over the coming months¹”.
Sterling Overnight Index Average (SONIA) options have moved to price in a >80% likelihood of this move in November – with a further single 25bp increase expected over the next two years (Figure one). So why have we had this recent reversal in interest rate expectations?
Inflation, Borrowing and the Pound
The BoE has a government-set inflation target of two percent. While deviations have been tolerated in periods of acute currency-led volatility – firstly around the Financial Crisis (2008) and then during the Euro Crisis (2011) the UK’s Consumer Price Index is currently running significantly above target, at 3.0% YoY. Even more importantly in the August Inflation Report the MPC’s central expectation was that inflation would still remain above target – at 2.2% – by Q3 2020. This forecast is even conditioned on two 25bp increases in UK Bank rate during the next three years. For a Committee that has managed to deliver an average UK inflation rate of 1.96% since 1998 (Figure two) this is a difficult backdrop to maintain interest rates at their historic low.
Alongside inflation concerns are a wider set of worries that are part of the delicate balancing act facing UK policymakers. A 42-year low in unemployment runs the risk of triggering long-awaited wage inflation, whilst unsecured borrowing totalling £204bn and growing at 9.9% YoY (Figure three) poses financial stability risks. Concern that recent macroprudential interventions to curb borrowing have not “got in all the cracks” simply adds to the argument for higher rates to deter overleveraging amongst households and businesses.
Finally there is the concern that as the Eurozone and U.S. economies begin to tighten their own monetary policies Sterling may face a renewed bout of weakness. A cursory eye-balling of the spread between 2-year Gilts and 2-year Treasuries and the GBPUSD exchange rate (Figure four) shows how sensitive currency-led inflation may be to a policy divergence between the Federal Reserve and the Bank of England. A hawkish Federal Reserve and a Bank of England sitting pat on interest rates is a recipe for further currency-led inflation in the UK economy.
So what is the likely impact if rates go up?
We wrote a piece for the Times last week – also available here – on why a single rate 25bp hike is nothing to fear. This simply returns UK Bank rate to the level it sat at between 2009 and 2016. Inflation expectations remain well-anchored (Figure five) at 2% – indicating that investors do not see recent above-target inflation spreading to a wage or price spiral. These factors point to the MPC proceeding cautiously given the challenges facing the real economy.
The Real Economy
Away from financial markets the backdrop to this policy decision is a real economy that has unquestionably slowed since last year’s Brexit referendum. This has been as consumers grapple with higher prices and firms have considered the possibility of Brexit-related disruption to well-established supply chains and regulatory equivalence. Recent output growth of 0.4% QoQ in Q3 indicates an economy stuck in third gear while the wider global economy accelerates away.
However many of the challenges facing the UK economy are political and structural weaknesses - rather than as a result of credit affordability or availability. Ahead of Thursday it is worth noting that interest rates remain extraordinarily low across all types of credit (Figure six) a 25bp increase will do little to change that. Heightened economic uncertainty over the next two years mean these accommodative credit conditions are set to remain a much-needed tailwind for the UK economy.