As widely expected, the Bank of England (BoE) raised its benchmark interest rate by 0.25% to 0.5% in the November meeting, with a majority of 7-2 voting in favour. This is the first rate increase in the UK for over a decade (the last time rates rose, the iPhone had been very first released). The Monetary Policy Committee (MPC) voted unanimously to maintain the stock of sterling non-financial investment-grade corporate bond purchases at £10 billion and UK government bond purchases at £435 billion.
With regards to forward guidance, all members agreed that future increases in Bank Rate would be ‘limited’ and at a ‘gradual pace’.
With Consumer Price Index (CPI) inflation hitting 3% in September, UK economic activity remaining resilient and a continuing erosion of spare capacity, the inflation tolerance of the BoE has clearly declined. Indeed, the MPC judged that inflation is unlikely to return to 2%, at least until 2021, without some further adjustment in monetary policy. In our view, with the unemployment rate at a 42-year low (and generally strong labour market data), resilient household consumption, real earnings likely past its worst and a strengthening external backdrop, reversing the 0.25% rate cut last July is wholly justified and ought to be reinforced by further rate rises in the coming year. That said, the outcome of Brexit negotiations remains an important determinant of policy outlook and the BoE will remain highly data dependent.
The BoE’s GDP growth forecasts are little changed but the unemployment rate projection has been revised down meaningfully. The expected path for CPI inflation has been revised marginally lower, although the expected Q4 2017 peak has been revised up to 3.0% from 2.8%. As noted above, without further policy action, inflation is expected to remain above the 2% target at least until 2021.
Our view is that, although the rise in UK inflation is largely attributable to sterling weakness, there is a risk that second-round effects could be greater than expected. Moreover, there could be a weakening in inflation anchoring if households and companies begin to incorporate higher prevailing inflation rates into expectations – with those expectations then feeding through into wage demands and price-setting decisions.
The 0.25% increase in interest rates is unlikely to have a significant impact on economic activity. The economy is still generating growth in employment, household debt as a percentage of GDP has come down and many households will still be refinancing at lower mortgage rates. Also, the banking system and company balance sheets are generally in solid shape.
The markets reacted to the MPC removing the line “monetary policy could need to be tightened by a somewhat greater extent over the forecast period than current market expectations” from the previous minutes. 10-year gilt yields fell by more than 8 basis points and sterling weakened by around 1.5%, as the markets perceived this as a dovish interest rate hike.