As the Monetary Policy Committee (MPC) turned more hawkish at its meeting yesterday, markets’ expectations of the next UK interest rate increase has been pulled forward to May 2018. We look at what caused the MPC to change its stance, its latest economic projections and policy implication.
The MPC unanimously kept policy unchanged at yesterday’s meeting, but delivered a more hawkish tone. There are two reasons behind this hawkish change of tone. The first one is growth: with the global economy growing at a rapid pace, the MPC expects external demand to continue to lift UK demand in the short to medium term. As a result, the MPC sees growth for 2018 and 2019 to be 1.8% (revised from prior projections of 1.6% and 1.7%) with both forecasts above those of the Bloomberg consensus. On the other hand, the MPC sees potential growth averaging just 1.5% over the forecast horizon. So, although the projection for UK growth is modest by historical standards, it is still expected to exceed potential growth and lead to a build-up in excess demand.
The second reason is inflation. Inflation is expected to remain around 3% in the short term, reflecting recent higher oil prices. Although higher import prices following sterling’s past depreciation will slowly dissipate, the MPC expects domestic inflationary pressures to rise due to higher wage growth. On balance, consumer price index inflation is projected to fall back gradually over the forecast horizon until 2021, but still be above the 2% target (at 2.11%) in three years.
The prospect of a greater degree of excess demand and the expectation that inflation would remain above the target over the forecast period have further diminished the trade-off that the MPC is required to balance. As a result, the MPC opines that “were the economy to evolve broadly in line with the February Inflation Report projections, monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November Report, in order to return inflation sustainably to the target.”
Based on market interest rates of three hikes over the next three years, the MPC projections show that such a pace of tightening will not be enough to bring inflation back to target. The implication is that more rate increases may be needed, and the MPC’s language reflected a greater sense of urgency on policy normalisation. Markets previously anticipated the next rate increase to happen toward the end of 2018, but now that expectation has been brought forward to May (the implied probability of a hike in May jumped to over 70% after yesterday’s meeting). Taking the Bank of England’s language and economic projections at face value, we now look for a rate increase potentially as early as May, or otherwise in August, but the timing will be dependent on both the progress of Brexit negotiations and economic data.