The Bank of England’s dovish hike

Chris Giles at the FT says that the Bank has questions to answer: about its reasoning; about the UK’s economic prospects; and about the way it communicates the future outlook for interest rates. For most of this year, City economists have converged on the view that in light of Brexit, the Monetary Policy Committee (MPC) would not touch interest rates until late 2018 or even 2019. But hawkish MPC members appear to be in the majority and make three separate arguments that form a case for tighter monetary policy. First, the economy has not been as weak as the Bank predicted in August 2016. Second, the BoE has been saying since the EU referendum that the long-term consequence of the Brexit vote would be to reduce the potential rate at which the UK economy can grow without sparking inflation. It is a bold call to raise rates on the back of something that cannot be measured. Third is that some MPC members think the current level of interest rates is more stimulative than it was, so a rise is needed to prevent too much borrowing and spending. Insiders at the BoE think that communication of monetary policy is as important as the level of interest rates itself. The big question will be whether the MPC will follow a rate rise on Thursday with further tightening of monetary policy.

Tony Yates at Long and Variable would have voted against a rate rise for various reasons. First, it’s possible to read into the Inflation Report that a reason to begin hiking is a change of view about the pace of growth of future output. If this is the case, then this is not itself a motivation for tighter policy, unless for some reason the path of demand for a given policy is to be judged to have stayed where it was. But in the kind of models the BoE uses for forecasting, demand would be expected to be correspondingly muted. Second, the effect of Brexit on inflation via Sterling’s depreciation – expected as it is to be temporary, even if persistent – can be entirely discounted and the remit gives the MPC leeway to do that. Third, if we strip out the temporary effects of the Sterling depreciation, we go back to the old position that the MPC are hoping to return inflation from below, to target ‘in a sustainable manner’. This was code language for discounting concerns that at the zero bound, when uncertainty is heightened, the MPC should set policy so that the most likely outcome is to overshoot the target, and not to hit it. Fourth, the pivotal judgement seems to be that slack is being used up, judging from extremely low levels of unemployment. Yet this evidence is not as decisive as it first seems. Whole economy nominal earnings growth is flat at about 2%, and much lower than would be consistent with trend. Private sector earnings growth has increased, but over a very short period, and from a very low base.  The policy decision rests almost entirely on future growth materialising as a result of forces that take hold now and in the future.

Simon Wren-Lewis published few days ago a short guide to why the rates should not have been hiked. UK inflation is currently around 3% because of the Brexit depreciation, which is temporary. The key is to look at whether average earnings inflation is responding to higher consumer price inflation, and the answer is that they are not: average earnings growth has been slightly above 2% in 2017, which is a little lower than the average for 2016. As for unemployment being at an historical low, Wren-Lewis argues that unemployment is not currently a good measure of labour market slack and that it is quite wrong to assume we know what the level of labour market slack is that would lead to increases in earnings growth (ie the NAIRU). So why would the MPC raise rates? Wren-Lewis suspects the MPC is worried that Brexit has created a negative supply shock, as both investment and productivity growth are much lower than the Bank were expecting before Brexit. He argues that this reasoning indicates a conceptual weakness, because by choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, which the economy instead desperately needs right now. Additionally, after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but the UK is currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009.

Duncan Weldon argues on Prospect Magazine that a rise in rates once meant that the economy was returning to normal health, but not this time. Although inflation is high and unemployment low, growth is fairly tepid, real incomes are being squeezed and Brexit-related uncertainty is weighing on business investment decisions. The important point to grasp is that the Bank is not being driven into hiking by a renewed sense of confidence in the UK economic outlook. Indeed its most recent forecasts show growth around the 1.6 to 1.7 per cent mark for the next two years against a pre-crisis average of almost 3 per cent. The Bank has become more pessimistic on the medium term outlook at the same time as loudly signalling that it feels the need to tighten policy. This is a hike driven by pessimism not optimism, by despair rather than hope. For a decade British productivity has been stagnant, and growth has been driven by using up spare capacity, hence unemployment falling to 40 year lows despite an historically weak recovery. The problem with that growth model, is that at some point the output gap will close, and as that happens, inflation will pick up. The majority of Bank policy-makers now appear to think the UK has reached this point.

Wouter Sturkenboom writes on the Russell Investment blog that the BoE’s mixed move - a rate hike coupled with a dovish forward guidance on the gradual path for future hikes - was a close call with compelling arguments in favour and against. The arguments in favour of the interest rate hike start with the rise in inflation to 3% year-on-year, which is putting pressure on the BoE to tighten monetary policy. However, because the rise in inflation is mainly caused by a fall in the pound, it is not the main reason. More important for the BoE is the tight labour market, as unemployment rate is at its lowest level since 1975 and economic growth in the UK has held up better than expected since the Brexit vote. On the against side, concerns around inflation need to be tempered considering the transitory impact of a weaker pound, and although wage growth might indeed pick up in the future, as of late it has been rather sluggish, putting pressure on domestic consumption, which has been the engine of economic growth since the Brexit vote. Sturkenboom believes the risks are tilted on the downside, and argues that a one-and-done rate hike against such a dovish forward guidance background will only briefly impact markets, pushing down gilt yields and the pound and supporting equities.

Mike Amey at Pimco Blog says that inevitably there are questions that follow the first rate hike – particularly whether this will be a solitary move, or the start of an interest rate cycle. The MPC will not want this to be seen as a solitary rise, but at the same time will not want to unsettle markets by guiding expectations towards a quick succession of hikes. Amey thinks it was a sensible decision on the MPC side to damp speculation of the latter case by dropping the language about the market being too sanguine about the path of future rates. Amey believes that market expectations for a cumulative 0.5% of additional interest rate rises by mid-2020 looks low, and that the MPC would rather like to follow a path similar to that of the Federal Reserve, which has raised rates by a cumulative 0.75% since its initial hike in December 2015.