UK reaction: BoE raises Bank Rate for first time in a decade, suggests more to come

UK reaction: BoE raises Bank Rate for first time in a decade, suggests more to come

Market commentary
02 November 2017

David Page, Senior Economist at AXA Investment Managers (AXA IM), comments on today’s Bank of England (BoE) meeting.

Key points:

BoE raises Bank Rate by 0.25% to 0.50% by 7-2 votes, the first hike in over a decade.

Governor Carney discusses a diminishing inflation overshoot/protecting jobs trade off in the light of a slower economy “speed limit”.

Bank projections are based around two further hikes over the coming three years, less than markets feared. Yields in rate markets and sterling fell.

Governor Carney stressed that developments in Brexit negotiations over the coming quarters could prompt a reassessment of the economic outlook and recalibration of monetary policy.

Assuming a transition arrangement over the coming months, we consider a modestly faster pace of rate hikes pencilling in another 0.25% Bank Rate hike in 2018 and two more in 2019.

The BoE voted 7-2 to enact the first monetary policy tightening in over a decade, raising Bank Rate by 0.25% to 0.50%. Markets had widely expected a hike following heavy messaging in September’s meeting minutes. However, the decision by two members (Deputy Governors Cunliffe and Ramsden) to leave policy on hold was fewer than markets expected, with new external member Tenreyro considered likely to dissent following recent testimony. The BoE left other measures of monetary policy unchanged, the asset purchase facility remained at £435bn and corporate bond quantitative easing at £10bn.

In the BoE press conference, Governor Carney suggested that the trade-off between projected-above-target-inflation and support to the jobs market was fading. He noted that despite growth below historic norms, unemployment was at a 42-year low, participation in the UK labour market was high and the estimated remaining slack in the near-term was slightly less than in August. After today’s hike (and assuming two more hikes, broadly one in 2018 and one in 2019) CPI inflation was expected to fall to just above the BoE’s inflation target of 2.15% by the end of the forecast period in end-2020. A projection based purely on today’s hike and no further tightening led to forecasts of inflation at 2.4%, something Governor Carney viewed as inconsistent with management of the BoE’s targets.

Governor Carney explained that at the heart of the BoE’s assessment was the fact that the UK economy was likely to expands above its supply potential, which the BoE estimates at around 1.5%. The BoE forecasts growth of 1.6% in 2017 (allowing for backcasts), 1.6% in 2018 and 1.7% in 2018 and 2019. Such an outlook was described as leaving the UK economy in a position of excess demand, with inflation a little above target by end-2020. Carney described this as the economy “running a little hot”, which he described as an appropriate balance of risks. Such an outlook is also predicated on an assumption of faster productivity growth emerging next year. The BoE forecasts productivity growth accelerating from an estimated 0.25% in 2017 to 1.25% in 2018 (revised lower from 1.5%), 1.5% in 2019 and 1.25% in 2020. As Governor Carney suggested, in broad terms, projections in today’s Report broadly endorsed an outlook of two more rate hikes over the coming three years. There was no repeat of the message that Bank Rate would likely have to rise more quickly than priced in markets.   

Yet the Bank of England does not provide interest rate projections; unlike the Federal Reserve, there is no “dot plot”. The rate outlook, Governor Carney described, was subject to significant uncertainty ahead. He described upcoming Brexit developments, particularly the resolution of uncertainty over the transition and eventual destination of Brexit as likely to require a re-assessment of the economic outlook and potentially a re-calibration of monetary policy. The Governor stressed that this was important insofar as household and business expectations were changed by developments. As such, developments in the run up to December’s EU summit provide a significant risk, with businesses expecting a transition and warning that contingency measures would be required if it were not forthcoming. February’s Inflation Report could therefore be significant in shaping the outlook for activity and monetary policy. February will also see the Bank’s annual supply-side review, also important given the importance the Bank attaches to the UK supply potential.

Judging by market reaction, the Governor can consider today’s hike as “job done”. The Governor managed to deliver the first hike in a decade, talk about the presumption of further hikes (moving discussion to when next from “one and done”) and avoid a sharp tightening in financial conditions. 2-year and 10-year gilt yields fell by 7bps and 5bps to 0.43% and 1.30% respectively. This reflected a reduction in interest rate expectations: short sterling contracts adjusting by 8bps by end-18 and 9bps end-19 and end-20; implied probabilities suggesting a greater than 50% chance of a second hike only by August next year, from May. This resulted in a 1% drop in sterling against both the dollar and euro and a modest rise in equities (FTSE up 0.2%).

Today’s Report was broadly consistent with our outlook. We can only agree with the BoE’s assessment that some resolution in Brexit uncertainty will be pivotal to the outlook and see the coming months as critical. We remain a little more cautious on the outlook for UK GDP growth forecasting 1.5% this year and 1.4% in 2018 and 2019. Relatedly, we also remain more cautious about the rebound likely in productivity growth next year. As such, we consider the likelihood of a further tightening in the labour market over the coming year, both resulting in the start of an acceleration in wage growth and feeding BoE concerns about future domestic inflation pressures. We also expect the BoE to maintain half an eye to any further sterling weakness, potentially reflecting the UK’s large ongoing external imbalance. Any such weakness would further exacerbate the inflation overshoot. As such, we forecast a modestly quicker pace of tightening in monetary policy than suggested today. We continue to look for a further 0.25% increase around the middle of next year. We then pencil in two rate hikes in 2019. This assumes both that the UK enters a 2-3 year transition deal on current terms, but also that productivity gains are slower to respond to this development than headline growth.       


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