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UK Interest rate poses a problem for the Bank of England

Publication Date: 19 Apr 2018 - By Market Mogul By Market Mogul
Actionable
Differentiated

Macro FX & Rates FX Fixed Income/Credit UK

Tuesday’s release of employment data gave rise to further optimism of a near probable rate hike from the Bank of England (BoE) in May. The current BoE base rate stands at 0.5%, with market participants pricing in an 85% chance of a 25 basis point hike after the release of strong employment data in the UK.

The unemployment rate was reported to be at its lowest level since 1975, at 4.2%. The Office of National Statistics (ONS) also released figures showing that there were record numbers of people in work, at 32.26m. The real driver of the rate increase expectation, however, was the strong wage growth figures. That growth, coupled with falling inflation, means that wage increases are nearing a real terms increase for the first time in years. Wages in the three months leading up to February, excluding bonuses, went up 2.8%, outstripping late March’s customer price index reading of 2.7%. Considering that consumer spending accounts for 60% of UK economic activity, this marks a significant boost as when wage growth picks up disposable incomes for families increase, meaning more spending in the economy.

Source: BBC

 

Source: ONS

Despite this, not all market participants think the hike is a done deal. Samuel Tombs, chief economist at Pantheon Macroeconomics, tweeted that year-on-year wage growth is only rising as a rebound to extreme wage rise weakness in 2017. In addition, figures show that the quarter-on-quarter annualised growth in private sector wages slowed to a ten-month low in February. Even with the recent rebound, these figures do not come close to the pre-crisis level of 4%. This evidence does not immediately suggest that an increase in the BoE’s base rate should take place. It may be better to instead be more dovish, and wait and see if this is a sustained trend.

Irrespective of this, the Monetary Policy Committee (MPC), the committee which sets the base interest rate, still faces a difficult situation. Inflation has been above target in recent months, yet there has been little response from the markets and consumers. Now may be the time to further slam the breaks on this cheap money environment.

Looking at the historical actions of the MPC, rates were slashed in the aftermath of the crisis, something done by almost all developed world central banks. As confidence in the financial system waned, central banks had to lower borrowing rates to stimulate spending and investment in the economy. The problem now is that as rates have been stuck at the so-called lower bound for a sustained period, the central bank faces the problem of not having any tools in its monetary box to respond to the next crisis. As seen in the chart below historically rates were much higher, almost 5% just over a decade ago. In recent times the BoE has cut rates down to a record 0.5% then further cut rates in the aftermath of Brexit to 0.25%, before raising them back to 0.5%. This has increased asset prices and caused some stimulus to the economy, but the BoE knows they can’t stay low forever.

Source: TradingEconomics.com

The BoE must tread carefully to avoid halting the progress of the recovery. Although inflation has been above target, this has mostly been driven by the effects of Brexit. Rising import prices had squeezed living standards over the past year and wages have not kept pace with inflation. These effects, alongside Brexit itself, have all contributed to the soft growth of 0.4% in the final quarter of 2017. As these factors dissipate and inflation reduces to nearer the targeted level of 2%, the key questions will be whether wage growth acceleration can be sustained and whether inflation remains volatile.

The MPC, therefore, must remain patient and not overemphasise the recent positive data points. It is important to realise there still are downside risks. One must not forget the incomplete Brexit transition, which although has more clarity, still requires ironing out especially on the crucial issues of the Irish border and the details of the UK-EU trade relationship after Brexit. Something that is out of the orbit of the UK potentially threatens not only the growth of the British economy but also global growth is the possible US-China trade war, as emphasised by Roberto Azevêdo when he said that such a trade war could have a severe impact on the world economy.

Slamming the brakes in an environment which has investors and corporations feeling at risk can have ramifications that could take years to rectify. The MPC themselves professed that a sign of an uptick in wage growth would be a reason to raise rates but, as these are only the early stages of wage flares, it doesn’t make sense to have a knee-jerk reaction to this. Thus the MPC must be mindful of its actions and having already allowed high inflation to simmer in the aftermath of the Brexit referendum they may feel it is time to finally take control of price rises in the UK. This, however, may not be the right time and patience in this environment may be the best action.

For all these reasons the MPC will need to take a gradual approach to hiking. Being both aggressive if need be, but also not being afraid to leave the cheap money accelerator on in order for the UK to encourage strong growth figures, which will foster a return to policy normalisation. All in all, it will be fascinating to see how the MPC responds to recent market events. The key to the MPC being successful will be its ability to discern what threats in the market are significant to growth and inflation and what threats are simply transitory.

The post The UK’s Interest Rate Poses a Problem for the Bank of England appeared first on The Market Mogul.

 

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