The events in world markets over the past couple of days have reminded me about something that I think is much more evenly balanced right now than assumed and that is the likely path of UK base rates. The conventional view is that multiple interest-rate increases are on their way and this is winning right now in UK markets. For example the UK ten-year Gilt yield has pushed through 3% today and is at 3.03% as I type this. In addition UK interest-rate futures are also predicting interest-rate increases as the December 2014 contract at 99.05 (or 0.95% if you subtract from 100) is predicting at least one 0.25% increase. By the time we reach December 2015 then a price of 98.20 or 1.8% involves between four and five base rate increases of 0.25%.
Why are they doing this?
The argument here is based on the recently strong performance of the UK economy where quarterly economic growth as expressed by the Gross Domestic Product numbers has gone 0.4%,0.7% and then 0.8%. If we use the business surveys -Purchasing Manager’s Indices or PMIs- we see that growth may still be accelerating.
November saw the already solid upturn in the UK
manufacturing sector gain further momentum. At
58.4, from an upwardly revised reading of 56.5 in
October, the seasonally adjusted Markit/CIPS
Purchasing Manager’s Index® (PMI® ) rose to its
highest level since February 2011.
Adjusted for seasonal factors, the Markit/CIPS UK
Construction Purchasing Managers’ Index® (PMI® ) registered 62.6 in November, up sharply from 59.4 in October and above the 50.0 no-change mark for the seventh successive month
The UK service sector maintained its recent run of
strong growth during November as incoming new
business continued to rise at a rapid pace……
After accounting for seasonal factors, the Business
Activity Index recorded a level of 60.0 in November.
Although a five-month low, and down from
October’s multi-year high of 62.5, the index again
signalled a historically sharp rate of growth.
As you can see the immediate outlook could hardly be more bright as good official numbers have been followed by even better business surveys. Indeed the compilers of the PMIs added this to their report.
When looked at alongside the upturns in the
buoyant manufacturing and construction sectors,
the three PMI surveys indicate that the pace of
economic growth will have accelerated in the fourth
quarter, rising to above 1.0%.
So it’s boom time Britain as we all raise a glass to (current) economic success. However there are two potential flies in the ointment here. Firstly business surveys can be prone to overestimating numbers at this stage of the cycle and every now and then they miss things completely such as industrial production in Ireland in October.
The dog that is not currently barking
We start to move away from arguments for interest-rate rises if we look at the current rate of inflation in the UK. The official Consumer Price Index is above its target of an annual rate of 2% but 2.1% is its nearest effort for over four years. Our previous inflation target of the Retail Price Index minus mortgage interest rates is in a similar position being at 2.6% as opposed to its target of 2.5%. If we look forwards to December’s figures we know that there are some utility price rises to account for but we also know that at 0.5% prices rose quite strongly last December so that an annual rate actually on target is conceivable.
So whilst the Bank of England is supposed to look 18/24 months ahead for inflation we have learnt over the credit crunch that it will use any excuse to predict that it will be on target. After all it sat on its hands when the official annual rate of inflation pushed above 5%. Actually hitting the inflation target would presumably do that job nicely as well as being a modern-day novelty! Thus the dangers of price pressure and overheating should the current mini-boom continue would be ignored and described later as “unexpected” and a “surprise” should they take place.
Monetary policy in the UK has in fact tightened
A theme of this blog since the early days of the Forward Guidance policy of Governor Mark Carney has been this. From August 8th.
The briefest ever easing of UK monetary policy? Perhaps. As the details of his plan emerged UK interest rate futures plunged and the pound’s exchange rate shot higher. If we look at the contract for June 2016 which had closed at 98.42 the day before those who thought that they had the “early wire” pushed it up to 98.56 before the announcement but afterwards it plunged to 98.24. At that point UK interest rate expectations had risen by a quarter point compared to the pre-announcement frenzy.
Next we move to the pounds exchange rate which soared from the depths of 1.52 to the heights of 1.55 against the US Dollar.
This led to the “dark side” theory which I have written about both on this blog and in City-AM. Monetary policy is claimed to be looser under Forward Guidance via what have become called “open market operations” but via future interest-rate expectations, currency movements and bond yields monetary policy tightens.
If we consider interest-rate expectations then the June 2016 future I referred too on the 8th of August is at 97.72 as I type this. So it is now pricing in around a further half a per cent of interest-rate increases since then or 2.28%.
The pound has rallied too and in the thin holiday market today has blasted higher. It looked at one point as if it would reach US $1.66 but has now faded back towards US $1.65. This might be a holiday squeeze but it is some 13 cents higher than when Forward Guidance was announced and will be having a strong anti-inflationary effect because most commodities are priced in US Dollars. The pound has also been strong against other currencies especially the Japanese Yen and just over the holiday period has gone from 170 to 171,172 and now 173 Yen.
Putting this another way using the past Bank of England rule of thumb the rise in the pound has been equivalent to a 1.25% rise in base rates on its own.
Also we have had this tightening of monetary policy
The Bank’s and HM Treasury’s announcement of changes to refocus the FLS to support business lending, by removing the direct incentives to expand household lending in 2014,
Also UK Gilt -government bond- yields have risen with the benchmark ten-year yield pushing above 3% to 3.03% as I type this. So monetary policy has tightened here too.
We know what the Bank of England thinks of this
At first the Monetary Policy Committee of the Bank of England noted the anti-inflationary effect of the strong pound, but its last set of official minutes presented a different view. The emphasis is mine. The sterling effective exchange rate index was near the top of the range it had occupied since early 2009, and had risen by around 9% since its recent trough in March 2013. Although the extent of the final pass-through to domestic prices was uncertain, that appreciation would contribute to disinflationary pressure.
But any further substantial appreciation of sterling would pose additional
risks to the balance of demand growth and to the recovery.
So should we see any slowing of the UK economy in 2014 and the exchange rate of the pound continues to be strong there are factors pointing towards a base rate cut. This would be reinforced if the pound strength actually pushed inflation to below its target. The MPC would be likely to ignore the years of inflation being above target and concentrate myopically on the immediate figures in such a situation. After all if eight people can wake up one day and discover that they all suddenly support Forward Guidance cutting base rates in such a situation might seem logical to them. This could be reinforced if as I expect we see more monetary easing from the European Central Bank early in 2014 as it via its currency and balance sheet is tightening policy right now.
Of course the thoughts here rely on circumstances which might change as, for example, the pound is looking somewhat elevated now and bond yields could fall back. But it is not priced in at all in my view. Also it gives us our first possible theme for 2014 when an apparent economic improvement can in the tortuous and convoluted economic world in which we now live end up being responded to with monetary easing. This leaves us with the question as to what set of circumstances would an official monetary tightening be considered appropriate if any?