25 February 2016
A UK rate rise could come sooner than markets think
Markets or MPC. Who is right?
by Frank O’Nomics
The Bank of England seems a little worried that markets are getting the wrong end of the stick. Market expectations for the next rise in interest rates in the UK have been pushed out from a period of just 8 ½ months at the start of this year, to a current horizon of 41 months, ie markets think that the 0.5% current Bank Rate will persist until well into 2019. The Bank’s Deputy Governor, Sir Jon Cunliffe, last week suggested that the market is wrong, and that such expectations are not backed by economic fundamentals, with the economy being “in the slow healing process from financial bust”. Sir Jon pointed to strong consumer confidence and business investment (while acknowledging concerns over productivity growth). He is not alone within the MPC in having concerns over market complacency on rates, with Martin Weale saying that he “would be surprised if people had to wait as long as markets are currently implying” and Ian McCafferty, while dropping a call for a rate rise now, has said that “upside risks to wage costs and prices have not disappeared….just pushed further out”.
The shift in market expectations seems essentially to be the market saying that rates will be unchanged for the foreseeable future, given that there are so many imponderables over a 3 ½ year period. Given that the lowering of rates to 0.5% was deemed to be an emergency measure (and remember this happened as long ago as March 2009), what has happened to suggest such a bleak economic outlook? In examining this we should also question the degree to which markets might be wrong – an important question for businesses who may be looking to borrow to invest, or for individuals who are looking to take out or increase a mortgage. One can quite easily imagine a modest shift in the global and domestic backdrop that would bring a rate rise much sooner.
In looking at why low rate expectations have been extended for so long, the obvious starting point has been China. Slowing growth in China has had a significant impact on the global economy, with the consequent fall in commodity demand helping to create low and falling inflation. A fall in global demand, concerns about potential job losses and a potential for deflation is more than enough to justify low interest rates and has been a prompt for further quantitative easing in both Japan and Europe. Steep falls in Asian stock markets have had a significant impact on developed markets, with FTSE recently hitting a point some 20% below the best levels of last year. This, together with a high level of stock market volatility, suggests that it would be rash to create added pressure by increasing interest rates. From a domestic point of view, some of the MPC’s concerns regarding a tight labour market seem to have receded over the last few months as pay growth has been weak, with average weekly earnings having fallen from a 3.3% growth rate in May, to just 1.9%y/y in January. Productivity growth slowed from 1.3% annualized in Q3 to just 0.9% in Q4, while CPI, despite picking up over the last 3 months, is still only running at 0.3%y/y, a long way from the MPCs 2% target.
However, it is dangerous to assume that these effects will continue, and a mere stabilization of global growth and commodity prices could have a significant impact. Oil prices may have further to fall, but do seem to have stabilised around $30 per barrel. Last week’s UK CPI data showed that alcohol and food prices are already starting to increase (they were offset by airfares) and if we just see no further falls in commodity prices over the next few months this can have a significant base effect on inflation, as the price falls from a year ago drop out of the calculation. The Bank of England forecasts inflation of around 1% next year, staying below 2% until 2018. The point here is that inflation is a lagging indicator and what is important is the direction of inflation at the key 2 year time horizon. The fan charts in the latest Bank of England Inflation Report show inflation at or near 2% in 2 years time (using assumptions of unchanged QE and market rate expectations). Firstly, this would seem to be a lot earlier than the market is now pricing in, and secondly, given that the chart is pointing upwards at the 2 year point, inflation is expected to exceed 2% if we extrapolate further. This would suggest that any change to inflation expectations (say from an OPEC production agreement) could prompt the MPC to act sooner, depending on other factors.
There is also a very big question to be asked regarding the impact of the currency on inflation. The strength of sterling over the last 2 years has been a significant suppressor of inflation, but there are signs that this may be starting to turn. The sterling–euro rate has recently hit a low for the past year and the pound had its biggest fall against the dollar for over a year, to a 7-year low, in response to Boris Johnson siding with the Britain out campaign. Given the importance of imported goods in the inflation basket, this is likely to have an impact on UK CPI, particularly given that retailers have little tolerance in their margins due to recent price wars which would suggest a high level of “pass-through” of a currency depreciation. Markets need to ask the extent to which sterling is likely to suffer into the Brexit vote, and what will happen if the country votes to leave. A 10% fall in the currency could increase inflation by around 2.7% (using data from previous moves), albeit over a number of years. This could create a scenario where rates are under pressure a long way ahead of 2019.
One positive factor that has been noted by the Bank of England has been the pick-up in business investment which, while it is expected to slow a little in the first half of 2016 to 1%, is still much stronger than the pre-crisis average of 0.5%, and should ultimately have some impact on disappointing productivity levels. Similarly, it may be dangerous to be relaxed about moderate wage growth when employment levels are continuing to rise. The working age employment rate at 74.1% is the highest since records began in 1971, and the unemployment rate of 5.1% is the lowest since 1975. If unemployment is close to its “natural rate”, a point below which inflation starts to rise, then the current low level of wage growth may prove somewhat transitory. In addition, there is growing pressure on employers to pay the National Living Wage, and this will be compulsory for workers over the age of 25 after this April. This rate (outside of London) is £7.20 per hour, rising to at least £9.00 by 2020, compared to the current National Living Wage of £6.70. Again, much of this increase will be passed on to consumers in the form of higher prices, thereby helping to push CPI closer to the 2% target.
So who will be right, the markets or the MPC? Well we are often advised that it is dangerous to bet against markets, except that here they do not seem to price in any risk of the alternative – which would seem to be even more dangerous. It seems we should watch currency, commodity and labour markets very closely.
