4th February 2016
Schroders senior European economist, Azad Zangana, comments on this weeks Bank of England (BoE) interest rate decision and Inflation Report…
The Bank of England announced on Thursday that it was leaving the main policy interest rate at the record low level of 0.50% – no change for the 83rd consecutive month – along with its asset purchase facility held at £375bn.
Importantly, external monetary policy committee (MPC) member Ian McCafferty has decided not to vote for an immediate increase in the interest rate this month, having voted for an increase in the previous six meetings. He joins the rest of the committee in voting for no change.
The shift in voting suggests that the balance of risks has shifted to the downside on growth and inflation. Indeed, the MPC meeting minutes suggest that the worsening international outlook has adversely impacted global commodity prices, international trade and has tightened global financial conditions. These factors are likely to be having a negative impact on UK growth.
The Bank not only lowered its forecast for GDP growth in the near term, but also for inflation as lower energy prices are expected to keep overall cost pressures near zero for longer.
The main challenge for the BoE is to communicate a more cautious message to the public and markets compared to the previous November Inflation Report, but not to change the overall message of the economy progressing well, and that interest rates are likely to rise in the future.
Markets currently place a greater probability on the BoE cutting interest rates this year, and are not pricing in a rate increase until the middle of 2018. The Bank, which uses the market’s path of interest rates to condition its growth and inflation forecasts, suggests that the market is not pricing in enough interest rate rises, and that should the BoE follow such a path, then inflation would overshoot the Bank’s 2% inflation target two and three years out.
Indeed, in the Inflation Report press conference, Governor Mark Carney was keen to signal that the MPC feels that interest rates are more likely to rise than not in the future.
Details of the latest Inflation Report also show that the BoE expects the labour market participation rate to stabilise at current levels, and for average hours worked to fall – resuming its pre-crisis trend. These suggest that there is less spare capacity in the economy than previously thought.
Indeed, the BoE expects excess spare capacity in the economy to be utilised by the end of this year, which should help wages to accelerate to support household demand. The Bank’s more hawkish assessment on spare capacity also suggests that the Bank is gearing up for the first rate rise since June 2007. The main obstacle to this is the anaemic rate of inflation.
Our forecast for the first rate rise is predicated on inflation being above 1% (the BoE’s lower target) and the economy growing at a steady pace. Based on our latest inflation forecast, this suggests the first rate rise may happen around the end of the year, or start of 2017.
However, one major difference between the Schroders forecast and the BoE’s is that we forecast GDP growth to slow in 2017 on the back of accelerated austerity and higher inflation. The BoE, on the other hand, expects growth to accelerate in 2017, from a temporary dip this year.
If the Bank is right, it should continue to raise interest rates at a steady pace through the whole of 2017. However, if growth slows as we expect, the Bank may have to pause its hiking cycle, or even reverse it. At present, the risks are clearly skewed towards rate hikes being delayed, perhaps indefinitely.