Bank of England Inflation Report: An economist’s view

12th February 2015

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February’s Bank of England Inflation Report suggests interest rate hike could happen around turn of year says Howard Archer chief UK & European economist 
at IHS Global Insight. Below he gives his view on the latest rhetoric from the Bank of England…

Coming into the Quarterly Inflation Report, our view was that it is touch and go whether the Bank of England first hikes interest rates at the end of 2015 or waits until early 2016. We maintain this view.

Looking at the consumer price inflation forecasts (and pretty buoyant growth projections) contained in the Quarterly Inflation Report and listening to Governor Mark Carney’s comments, it looks like the markets had got ahead of themselves in not expecting any interest rate hike before mid-2016.

READ MORE: UK inflation to turn negative this year says Bank of England boss

Mark Carney’s letter to Chancellor George Osborne explaining why inflation has dipped more than one percentage point below its 2% target level and what the Bank intends to do about returning it to its target rate and over what time horizon also points to a gradual rise in interest rates most likely starting around the turn of the year.

True, the Bank of England now forecasts consumer price inflation to average 0% in the second quarter and 0.1% in the third quarter and acknowledges that it could briefly turn negative “as energy and food price inflation continue to weigh on the headline rate”.

The Bank has also stated that if deemed necessary, it now feels that it could take interest rates lower than the current rate of 0.5% and it could also do more Quantitative Easing.

But the Bank of  England argues that “a temporary period of falling prices driven by large adjustments in a few specific components of the CPI is a fundamentally distinct phenomenon from “deflation”, which is characterised by persistent and generalised declines in prices.” The bank points out that  roughly two-thirds of the weakness in UK inflation comes from energy, food and other goods prices. It also argues that temporarily negative inflation rates driven by falls in commodity prices actually boosts the UK economy as it  lifts households’ real pay.

Indeed, the Bank of England believes that lower energy prices, along with rising wage growth, will contribute towards the UK economy growing more than it previously expected.  Year-on-year growth is now seen at 2.88% in the fourth quarter of 2015 and 2.81% in the fourth quarter of 2016 compared to 2.65% and 2.63% respectively in the November Inflation Report.

Most tellingly though, the Bank of England stresses that it is important to look through the current weakness in consumer price inflation and possible near-term deflation, and focus on the longer-term.

Critically, the Bank of England’s new consumer price inflation forecasts show inflation moving up steadily from the fourth quarter of 2015 as the impact of falling energy and food prices drop out of the year-on-year comparison and the amount of domestic slack in the economy (now estimated to be down to 0.5% of GDP) is absorbed.  Specifically, consumer price inflation is seen rising to the target rate of 2% in the first quarter of 2017 and then edging up thereafter to stand at 2.2% in the first quarter of 2018.

At the time these forecast, were made, the markets were pricing in a first interest rate hike around mid-2016 followed by gradual increases. So while the Bank of England is stressing that interest rate rises when they come will be gradual, by projecting consumer price inflation just above its 2.0% target rate in 2017, it looks like the bank currently believes interest rates will need to start rising around the turn of the year.

It is also notable that the markets have recently brought forward their expectation of the first interest rate hike from around mid-2016 to early-2016, and Mr. Carney commented that the market “understands in general what the MPC is trying to do”.

There are of course major uncertainties – both to the upside and downside – to the growth and inflation outlook. Potential political uncertainty around the general election and events in the Eurozone are obvious examples.

Outlook for interest rates

We maintain the view that it is borderline as to whether the Bank of England starts to raise interest rates at the end of this year or holds fire until early 2016. At the latest, we expect the Bank of England to raise interest rates from 0.50% to 0.75% by February 2016.

Given that the Bank of England has stressed the importance of looking through recent and likely further near-term very weak inflation developments resulting from sharply reduced oil prices and focusing on the medium-term inflation outlook, an interest rate hike late on in 2015 still looks a very real possibility.

Nevertheless, while extended deflation does not appear to be a serious risk in the UK, the very real prospect that consumer price inflation will briefly dip below 0.0% during the early months of 2015 and will likely be below 1.0% through to the end of this year could yet make the Bank of England wary about raising interest rates at all in 2015, even if growth holds up well. Much will clearly depend on just how much UK wage growth picks up as 2015 progresses and whether inflation expectations weaken markedly.

In reality, it will not make a huge difference to the economic outlook as to whether the Bank of England first hikes interest rates from 0.50% to 075% in late-2015 or early-2016.

Regardless of whether the Bank of England first acts late on in 2015 or waits until early 2015, we see interest rates rising gradually to 1.50% at the end of 2016 and to 2.50% at the end of 2017. This is based on our expectation that growth will hold up pretty well and that consumer price inflation will get back up to 2.0% by early-2017. Even so, the Bank of England will not raise interest rates aggressively because of a combination of factors including still relatively high consumer debt levels, the potential impact on sterling and the risks to UK growth coming from extended Eurozone weakness.

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