UK reaction: BoE on hold, but revised GDP forecasts raise the chances of a hike

David Page, Senior Economist at AXA Investment Managers (AXA IM), comments on the Bank of England meeting today concluding that revised GDP forecasts raise the chances of a rate hike.

 

Key points:

• Bank of England (BoE) left policy unchanged by unanimous vote.
• February Inflation Report forecast changes revised GDP growth up to 2.0% (from 1.4%) for 2017, 1.6% (from 1.5%) for 2018 and 1.7% (from 1.6%) for 2019.
• Simultaneous upward revisions to estimates of the UK supply capacity (NAIRU dropping to 4.5% from 5.0%), sterling appreciation and a rise in market rates neutralised the expected impact on inflation.
• Forecasts (and policy appropriateness) rests on key judgements to be tested over coming months.
• Our outlook is consistent with the BoE key judgements. As such we continue to forecast Bank rate unchanged across 2017. But we acknowledge risks of tighter policy are growing.

“The Monetary Policy Committee (MPC) left monetary policy unchanged in February as widely expected: Bank rate at 0.25%, the asset purchase facility (APF) target at £435bn and £10bn for the corporate bond purchase programme. The MPC was unanimous in its decision. In its medium term Inflation Report forecasts, the Bank made a number of material changes. Its decision that policy is appropriate is based on a number of key judgements. As economic uncertainty is currently elevated in the light of the UK’s decision to leave the European Union (EU), risks surround these key judgements. This could leave the MPC tightening monetary policy in 2017, although our forecast remains that policy will remain unchanged at 0.25% throughout 2017.

“Governor Carney’s press conference began by explaining that the Bank was balancing the expected overshoot of inflation caused by sterling’s decline against a period of weaker activity still anticipated in the economy. However, he warned that the Bank’s tolerance for an inflation overshoot was limited, particularly in the face of firmer GDP growth.

“The Bank revised its GDP growth forecast for 2017 higher to 2.0% from 1.4% in November and more modestly to 1.6% and 1.7% (from 1.5% and 1.6%) for 2018 and 2019. The upward revision was driven by the Chancellor’s fiscal measures in November (accounting for half of the upgrade); a higher global growth forecast (accounting for a quarter); easier financial conditions; and few signs of households anticipating a squeeze in their incomes.

“Following the BoE’s annual supply review, the BoE has increased its estimate of supply capacity in the UK. It now believes the natural rate of unemployment is 4.5% compared with 5.0% previously (reflecting for example labour market flexibility, demographic change, benefit changes). This helps explain still subdued pay growth in the UK, despite a low rate of unemployment. Accordingly, the BoE has lowered its pay growth forecasts, now projecting growth to rise to just 3.25% over the coming years (from 3.75%).

“Increased supply capacity combined with a 3% appreciation in sterling (since November) and modest rise in market implied rate forecasts broadly neutralised the impact of a firmer demand forecast. The BoE’s inflation projection was broadly similar to November’s forecast – allowing for the extending time horizon. Inflation was seen peaking at 2.8% in 2018 and softening to 2.4% in 2019. Accordingly the MPC continued to see the current stance of monetary policy appropriate.

“The MPC’s projections are based on a number of key judgements. A suggestion that these judgements are wrong would suggest a future change in outlook with possible policy implications. Governor Carney stated that crucially, the Bank would monitor

• Inflation (and its reaction to sterling) and inflation expectations.
• Wage growth remains modest as forecast.
• Consumer spending softens reflecting the impending squeeze in real incomes.

“Given the significant uncertainty surrounding the UK economic outlook and its resilience to date from the Brexit vote, there is a material chance that there is some deviation in these judgements.

“We expect inflation to rise modestly above the current Bank view (we see a peak of 3.1% in 2018, in part based on a modest further softening in sterling), but see inflation expectations as remaining well anchored. We forecast earnings rising to just over 3% in 2018, before accelerating into 2019. And we forecast a deceleration in consumer spending, that underpins our assumption of a more material weakening in 2017 GDP than the BoE now projects. As such, we remain of the view that Bank rate will remain on hold into 2018. However, we too are wary that UK economic resilience persists and see a growing risk that the MPC may have to tighten policy later in 2017.

“Financial markets reacted dovishly to the Bank’s announcement, apparently fearing a more hawkish assessment from the BoE. 2 and 10-year gilt yields fell by 2bps and 6bps (to 0.11% and 1.38%) respectively; sterling fell 1% from session highs and equities posted modest gains, FTSE 100 +0.4%.” 

ENDS