Following the Brexit vote, the Bank of England (BoE) cut its official interest rate by 0.25% in August and signalled the potential for another cut by the end of 2016. The BoE warned of a murky economic outlook as it slashed its 2017 UK growth forecast to 0.8% (from 2.3%) and suggested that the unemployment rate would reach 5.6% by the end of 2017 (from 4.9%). At one point, market expectations for the UK’s first interest rate hike were pushed forward as far as the second half of 2022.
After a temporary dip in sentiment indicators in July, UK economic activity has proven surprisingly robust. Indeed, for 2016 as a whole, the UK was the fastest growing economy in the Group of Seven (G7). Better growth prospects, along with the rising trend in inflation, have led markets to reduce significantly the expected moment of the next rate increase by four years to the start of 2017.
In its latest Inflation Report in February, the BoE raised its projections for GDP growth (based on market interest rates path) to 2.0% in 2017 (from the 1.4% it forecast in November) and to 1.6% (from 1.5%) and 1.7% (from 1.6%) in 2018 and 2019, respectively. According to the BoE, the upgraded outlook over the forecast period reflects the fiscal stimulus announced in the Chancellor’s Autumn Statement, firmer momentum in global activity, higher global equity prices and more supportive credit conditions, particularly for households. In reality, however, the BoE had previously been way too pessimistic.
Interestingly, the BoE now believes there is more slack in the economy and has lowered its estimate of the equilibrium unemployment rate to 4.5% from 5%. It believes some degree of remaining slack in the economy and only modest productivity growth will keep wage growth relatively subdued. Conveniently, you might think, this implies the unemployment rate can fall further without generating as much domestic inflation pressure as previously thought. Accordingly, inflation projections saw insignificant revisions relative to growth. CPI inflation is expected to pick up to 2.8% by Q2 2018, mainly due to the effect of weaker sterling, before falling back gradually to 2.4% in three years’ time. It should be added, however, that inflation will be above the 2% target for the whole of the forecast period, although the Governor claimed this would be solely the result of previous sterling weakness.
We think the BoE has demonstrated its inflation tolerance by “shifting the goal posts” and may continue to look for excuses not to raise interest rates. The testing time will come if wage growth strengthens more than expected later this year. The supposition that there is more slack in the economy than previously thought keeps the central policy line at neutral for now. However, there is a clear risk that productivity does not improve as forecast by the BoE and that a continued tightening in the labour market results in greater than expected wage inflation. This would push up domestically-generated inflation and would increase the pressure on the MPC to raise interest rates earlier than markets currently anticipate (by the end of 2018).