20 June 2019
UK Rate Rise?
Weak growth will stay the hand of the Bank
by Frank O’Nomics
Moderate growth, relatively benign inflation and Brexit uncertainty has helped keep UK interest rates unchanged since August 2018. However, signs of wage growth have put the wind up a number of Bank of England Governors, who warn that it may be hard to resist a rate rise for much longer. Many of us have long argued that steady and stable growth presented an ideal opportunity to move rates back towards a “neutral rate”, closer to 2%, to discourage excessive borrowing which could undermine the financial system, and to create room for a stimulus, should there be a post-Brexit recession. The problem with this argument now is that the slowdown that we feared, both global and domestic, appears to be upon us. Raising UK interest rates now could prove to be one of briefest bank interventions on record.
First let’s look at the arguments for putting rates up now. One external member of the Monetary Policy Committee, Michael Saunders, recently suggested that the economy is at capacity and hence inflation is a risk. The Bank’s Chief economist, Andy Haldane, has said that a rate rise may be needed to “nip any inflationary risk in the bud”. Yet another governor, Ben Broadbent, told the Treasury Select Committee that rates may have to rise by a little more than was forecast in May, when just one 0.25% rate rise (to 1%) was predicted over the next 3 years. One of the factors that has changed the Bank’s perceptions of the inflation outlook is wages. Pay is up 3.4% over the past year and, with unemployment at its lowest level since 1974 (3.8%), the risk of further pay rises due to demand and skill shortages are creating some concern. The Bank has also been re-evaluating its assessment of business investment, the low levels of which had previously been seen as a constraint on growth. Jonathan Haskel, another external member of the MPC, argues that business investment may have been much stronger than thought due to official estimates underestimating spending on intangible assets such as software, data and branding. Of the 9 MPC members there are at least 4 who could conceivably be voting for a rate rise quite soon.
In looking at the reasons why, even it were to happen, any move would be transitory one should look to the global outlook. The US-China trade war is undoubtedly having an impact on both major economies, with the US now looking like as if it is growing at an annual rate of 1.5% against the 3.1% registered in the first quarter. The one bright spot for the US had been a very robust employment market, but the latest data has shown a significant slowing in job creation. Any imminent cut in US rates may be curtailed by the Fed Governor, Jerome Powell, being reluctant to be seen to cave in to pressure from Donald Trump, but the US yield curve suggests that it is only a matter of time. As for Europe, this week ECB President Mario Draghi said that additional stimulus will be needed if the economic outlook does not improve and pointed out that its quantitative easing programme “still has considerable headroom”. The point here is that any interest rate rise in the UK would be at odds with the rest of the world, and putting rates up to defend sterling may not be necessary if the other currencies weaken in the way that the Euro did in response to Mr. Draghi.
If it can be argued that the international backdrop does not support a rate rise, what of the domestic economy? Yes, we have strong labour market and wage growth is (finally) picking-up. However, most other economic indicators are showing an entirely different picture. UK GDP shrank by 0.4% between March and April, the second monthly fall in a row, with manufacturing particularly hard hit as vehicle production fell a staggering 24%. The CBI has said that growth has ground to a halt over the last 3 months and the Treasury model points to a contraction of 0.2% for the current quarter. It takes 2 quarters of negative growth to register a recession and, while Q1 showed strong growth, it was largely due to pre-Brexit stockpiling – we may be closer to the feared malaise than we think. Construction companies’ order books, a key component of recent growth have shrunk by over a third in the past year, and the mess on the high street continues with 53% of companies reporting a fall in sales volumes. It would appear that the only sign of life has been in the wage growth number that is the concern of some members of the MPC. Not for the first time are economists getting overly concerned by lagging economic indicators. UK employment is robust, and the gig economy means that there has been little need for redundancies hitherto, but we have already seen a 2.4% annualised drop in those employed in the retail sector. Further, wage growth spent such a long time in negative territory in real terms that some extended correction should really be welcomed rather than responded to.
Despite the surprisingly high number of MPC members expressing inflation concerns and raising the prospect of a rate rise, it seems unlikely that they will win the day. Neither the international or domestic outlooks ultimately support such a move and there should be sufficient MPC members to oppose it. Gertjan Vlieghe, for one, has pointed out that global and domestic downside risks “have both intensified”. Governor Mark Carney, who has pointed out that around two thirds of changes in US rates will spill over into the UK, may be criticised for missing the opportunity to sanction a move in rates closer to their neutral level when it was justified some months ago, but on this occasion his inertia would actually be well justified.
