The Federal Reserve’s Federal Open Market Committee (the Fed) and the Bank of England’s Monetary Policy Committee (the BOE) have just held their monthly meetings.
The Fed signalled that interest rates will not rise anytime soon and indicated a decisive shift in its thinking on inflation and the interest rate cycle. As a result, we believe the US federal funds rate will remain unchanged in 2019 and that the Fed has likely finished increasing rates in this cycle.
The most dovish element to come out of the latest Fed meeting was the downward move in the committee members’ expectations for interest rates. On average, they now expect no interest rate rises this year - compared to two increases in the last release.
The bar for any adjustment to policy guidance is now high. To justify a rate increase, the Fed would require a sustained uptrend in inflation and much stronger growth.
The Fed also said that, from May, it would slow its sale of Treasury holdings to $15 billion per month from $30 billion currently. It will end the programme in September.
Significantly, the Fed changed its description of economic conditions in its official Policy Statement. It said economic activity had “slowed from its solid rate in the fourth quarter” having described it as “rising at a solid rate” in January. This was accompanied by a cut to the Fed’s GDP growth forecasts: the 2019 forecast was reduced to 2.1% from 2.3% while the 2020 forecast was lowered to 1.9% from 2.0%. The Fed maintained its forecast for core inflation of 2.0% to 2021, but lowered its forecast of headline inflation to 1.8% at year-end 2019 from 1.9%.
We believe the Fed’s stance risks creating complacency. Markets now expect rates to remain on hold for the foreseeable future. If inflation and growth start to regain momentum, markets will start to question the Fed’s guidance which could result in future volatility.
The Bank of England's decision to keep policy on hold was expected. The current policy stance remains highly dependent on Brexit negotiations – which remain uncertain. The BOE has indicated that Brexit outcomes could prompt rate moves in either direction.
What we said on 8 March...
The European Central Bank has followed the lead of the US Federal Reserve and indicated that interest rate rises will be pushed further back.
On Thursday the ECB stated that “the Governing Council now expects the key ECB interest rates to remain at their present levels at least through the end of 2019”.
This compared to January’s reference to rates remaining at current levels “at least through the summer of 2019”.
The change in guidance was somewhat unexpected, but markets had in any case priced out the likelihood of an increase this year. Markets now anticipate a first ECB increase in mid-2020.
The ECB also announced a new series of targeted longer-term refinancing operations (TLTROs), to commence in September this year, running through to March 2021. These are one of the ECB’s tools to incentivise banks to lend to businesses and consumers.
TLTROs were widely anticipated, but the announcement at yesterday’s meeting came earlier than expected. On the positive side, the incentive for banks to lend will support favourable credit conditions. But markets are seemingly disappointed by this issue of TLTROs: the duration is only 2 years, compared to 4 years previously.
European economic outlook
The ECB revised down growth and inflation forecasts (particularly sharply for 2019 GDP growth), providing justification for the more dovish tilt in policy guidance.
But the ECB judges that the probability of recession is very low despite this more downbeat assessment.
What we said on 8 February...
The Bank of England’s Monetary Policy Committee (MPC) made the unanimous decision to keep rates unchanged at this week’s meeting – as the market expected.
The meeting’s main outcome was that Brexit uncertainty, among other global headwinds, caused the MPC to cut UK growth forecasts sharply.
Growth in 2019 is now forecast at 1.2% (down from 1.7% in November) and growth in 2020 is at 1.5% (down from 1.7%). The revision wasn’t entirely Brexit-related: the MPC also revised down its global growth forecasts.
Inflation forecasts are little changed: based on one interest rate increase over the forecast horizon, inflation (CPI) is projected to rise to 2.1% by the end of 2021.
As ever, all hangs on Brexit outcome…
Despite the more bearish near-term growth forecasts, the overall policy guidance remains unchanged – but is contingent upon the Brexit process unfolding in a certain way.
If there is a smooth transition on Brexit, then an ongoing tightening of monetary policy at a “gradual” and “limited” pace will be appropriate. This is because the MPC still sees excess demand growth - and hence domestic inflationary pressure - emerging over the forecast period.
Given the considerable uncertainty and binary nature of Brexit outcomes, the Bank of England (BOE) undertook some GDP growth and inflation sensitivity analysis to a 5% appreciation/depreciation in sterling – see the table, below.
Source: Bank of England
Even in the scenario of a smooth Brexit transition, the BOE’s forecasts imply a one-in–four chance of a UK recession this year.
Given the MPC’s downbeat assessment of UK and global economic activity, we think the bar is set high for any potential rate increase.
What we said on 1 February...
The Fed changes tack and indicates the next movement in rates might even be down
There was a sudden switch in tone at the Federal Reserve’s first meeting of 2019 on 30 January.
As recently as December the rate-setting Federal Open Market Committee (FOMC) had led markets to expect further rate increases in 2019.
But in what some commentators have described as a U-turn, the Fed adopted a strikingly different position – describing its position as “patient” and saying it no longer has a strong bias in whether the next rate move will be up down.
Striking another dovish note, the Fed also said it will be flexible on its “balance sheet normalisation” – the process of reversing quantitative easing – suggesting it is not on autopilot and will be very data-dependent in upcoming actions.
Could the next move in interest rates really be downward?
We do not think the data warrants a rate cut yet. That said, in our view the bar for a next rate increase is now high: the Fed probably needs to see some resolution of trade tensions, sustained improvement in financial conditions and a firmer trend in core PCE inflation.
Equity markets responded positively to the adjusted stance.
With a more patient and flexible Fed, US dollar weakened, equities rose and Treasury yield fell, in particular at the short end.
What we said on 14 December...
European Central Bank confirms "normalisation"
The ECB has confirmed it will stop its €30 billion monthly purchase of bonds, otherwise known as “quantitive easing”, as of the end of this month.
This draws to a close an unconventional monetary policy which – alongside ultra-low interest rates – was key to the ECB’s efforts to provide accommodative financial conditions and stimulate economic activity in the Euro area.
The US, UK and Japan also deployed QE, but started earlier than the ECB, whose programme of bond purchases began only in 2015. Since then the ECB’s QE has pushed more than €2 trillion into the economy.
The announcement of the end of QE was expected and there was little market reaction.
Maturing bonds purchased under the programme will be re-invested, and the ECB is expanding the window in which to make the reinvestment from three months to one year. Reinvestments will be made in their original jurisdictions.
These measures should help ensure a smooth functioning of markets in the wake of QE.
The ECB stressed that QE remains a permanent part of its toolbox and will deploy it as it deems necessary
Outlook for Eurozone interest rates 2019
The ECB is keeping rates on the main refinancing operations, marginal lending facility and the deposit facility unchanged at 0.00%, 0.25% and -0.40% respectively, and has stressed rates will be kept low for as long as necessary.
The market is now pricing the first interest rate increase in the Eurozone to occur in early 2020. While Mr Draghi did not endorse or contest this view, he suggested that easing financial conditions could lead to a pick-up in growth that would allow an increase to arrive sooner.
We now expect the first rate increase to take place in September 2019.
There are modest downgrades to growth forecasts for 2018 and 2019. These reflects the ECB’s view that risks are now “moving to the downside” because of concerns including geopolitical risk, trade protectionism and market volatility.
While acknowledging the increase in general uncertainty and weaker economic data, Mr Draghi cited some improvement in the trade situation and stronger activity in emerging markets compared to a few months ago.
The ECB also noted that while weaker data reflected softer external demand and also some country and sector-specific factors, the underlying strength of domestic demand continues to underpin the Eurozone expansion and gradually rising inflationary pressures.
What we said on 30 November...
Jerome Powell, Chairman of the US Federal Reserve, said in a speech this week that interest rates are currently “just below” what many economists estimate to be a “neutral” level.
Currently the “neutral” position is reckoned at between 2.5% and 3.5%, while the actual rate sits at 2.25%.
Mr Powell’s "just below" remark suggested the Fed is more inclined to pause its schedule of increases – or at least adopt a less determined stance. In response to his comments US shares lifted sharply.
Underlying inflation in the US is rising, but not aggressively. The slump in oil prices has prompted many economists to revise down inflation forecasts.
Solid but slowing US economic momentum, coupled with the indications in Mr Powell’s speech, mean the market’s expectation of further increases in 2019 has been substantially revised.
Markets are now pricing in just one increase in 2019, as opposed to the two previously forecast, and no increase at all is forecast for 2020.
What we said on 26 October...
Markets were not expecting the ECB to announce policy changes in October’s meeting – what they were focusing on was the tone of ECB President Mario Draghi’s commentary and what he said about the emerging rift between the European Commission and Italy over the latter’s draft budget.
Interest rates were left unchanged and the Bank still anticipates ending quantitative easing by December 2018. Rates are not expected to increase until summer 2019 at the earliest.
Mr Draghi made an effort to avoid sounding negative or “dovish”.
On growth, he acknowledged weaker momentum but contrasted that with the exceptionally robust growth in 2017. The ECB’s overall position is that even when the risks of trade disputes, vulnerability in emerging markets and financial market volatility are factored in, economic outlook remains broadly balanced.
On inflation, Mr Draghi highlighted the tightening labour market and higher wages. He was clear in identifying the trend of rising inflation and reiterated that the ECB mandate is price stability. It certainly sounds as though policy normalisation remains the Bank’s base case.
The Italian problem…
Mario Draghi faced many questions on the Italian downgrade and budget situation following the decision by the European Commission earlier this week to reject Rome’s draft spending plans for 2019.
Mr. Draghi said he expected an agreement between the Italian government and the Commission be reached at some point. For now the spill-over is limited.
Overall our view is that there will need to be marked deterioration in the wider world economy for the ECB to change its current monetary stance. The December meeting will be crucial as new macroeconomic forecasts will give a clearer view of 2019.
What we said on 15 October...
Inflation in the UK dropped from 2.7% to 2.4% in September, unwinding the summer-related surge that came in part because of a spike in package holiday prices (see below).
Despite this movement inflation remains solidly above target. Several factors look set to keep inflation elevated including higher energy prices, higher imported food prices and stronger wage growth. Nominal wage growth, at 3.1%, is at its highest since 2009.
The MPC is likely to focus more on rising wages as a source of domestic price pressure, rather than read too much into September’s lower figure. But the timing of the next movement rests very much upon progress made in Brexit negotiations. We continue to expect no change in Bank rate before March 2019.
What we said on 28 September…
The Federal Open Market Committee raised the Fed funds rate as expected by 0.25 percentage points at its September 26 meeting, bringing the benchmark interest rate to 2.25%.
The expectation is that there will be one further increase before the end of this year and three more in 2019.
This is the eighth increase since 2015. The committee sees continued strength in the US economy and does not appear to be putting emphasis on risks such as an escalation in trade tensions.
What we said on 5th September...
Inflation rose by more than expected in August, with headline inflation up from 2.5% to 2.7%. By contrast, the market was anticipating a slight decline to 2.4%.
Transport, clothing and recreation were big contributors to overall price rises. Transport fares reflected higher fuel prices while the jump in recreation costs was due to package holiday prices – which could be temporary.
Energy prices appear to have peaked, while we expect food prices to rise further as prices of imports accelerate again.
What will this mean for the Bank Rate?
One month’s data is unlikely to change the Monetary Policy Committee’s (MPC) stance for now, and we continue to expect no change in the Bank rate before March 2019. The timing of the next increase still depends much upon Brexit and the progress – or lack of progress – in the negotiation process.
However, the data does suggest domestic price pressures are building. If some form of Brexit agreement is reached and we move smoothly to the Brexit transition period, the MPC may be inclined to bring increases forward. Following this latest inflation data, markets have brought forward their expectation of the next rate rise slightly, boosting gilt yields and sterling.
Markets still point to May 2019 as being the point at which the Bank Rate will next increase.
Strong US manufacturing suggests the Fed will raise rates this month, despite trade tensions
Despite anxiety around the prospect of further escalation in the US-China trade spat we expect US interest rates to continue to rise in line with our previous forecasts.
This follows surprisingly strong US manufacturing data released on 4 September.
The Institute for Supply Management’s (ISM) manufacturing index surged to a 14-year high (and near-35 year high) in August, coming out significantly higher than expected.
The report showed new orders at a seven month high, while inventories, production and order backlogs also picked up during August, reminding us of the underlying strength in the US economy. However, almost two-thirds of survey respondents reported higher input costs due to trade tariffs, so the impact is inflationary if these higher costs are passed on to consumers.
We are monitoring the ISM as a key way of tracking corporate reactions if the US administration goes ahead with the next stage of tariffs on $200 billion of Chinese imports. But this latest ISM report suggests trade tensions have had a limited negative impact so far on domestic economic activity – giving the Fed scant reason to pause its policy of gradual increases. A rate increase this month is almost fully priced in.
What we said on August 15th...
Inflation rose for the first time in eight months – driven largely by an increase in the price of popular computer games. Headline inflation as measured by the Consumer Price Index ticked up by one tenth of a percentage point to 2.5%, in the latest data published on 15th August.
Energy prices and cultural spending showed the biggest rises. The latter category includes computer games, where prices are volatile. Overall, these increases were offset by the year-on-year fall in prices for other major consumer categories including clothing, footwear, furniture and household goods.
The effect of weaker sterling on future inflation
Falling prices of clothing and other items suggest that the inflationary effects caused by the post-referendum drop in sterling – which triggered a rise in the prices of imported goods – is now fading.
But renewed sterling weakness more recently suggests we will see a modest increase in the price of imported goods.
UK inflation data released on 15th August suggests the Bank of England will keep rates on hold for the rest of this year. The timing of the next rate rise, which we expect to be in 2019, will depend significantly upon progress made in the Brexit negotiations.
What we said on August 2nd...
The Bank of England has raised the benchmark Bank Rate by 0.25 percentage points to 0.75% at its August meeting on Wednesday.
This was widely expected, but the slight surprise is that all nine members of the rate-setting Monetary Policy Committee (MPC) voted for a rate increase. They also agreed that further rate increases will be needed to bring inflation back toward its long-term target of 2% (see below).
The MPC sees UK economic growth running at above its potential rate of 1.5% per year in the next two years, despite the risks posed by Brexit and rising global trade tensions. In turn it expects inflation to run above target for longer than previously thought - giving rise to the likelihood of further interest rate increases.
Interest rates remain near their historic lows
At 0.75%, the Bank Rate is still far lower than at any point in the latter half of the last century.
The latest increase is only the second in 11 years (scroll down for “The Brexit Effect”) and means that until now the Bank Rate has been at 0.5% or below for 113 months.
What about the long-term outlook for the Bank Rate?
The main aim of the Monetary Policy Committee (MPC) is to meet the target of 2% inflation, in a way that supports economic growth and employment.
This means that at certain periods the MPC is tolerant of inflation which exceeds the 2% level. To some extent that is what has happened in the recent period, when a collapse in the value of sterling caused the prices of imported goods to rise.
The decision to raise rates to 0.75% rested in part on the Monetary Policy Committee’s fear that with unemployment at a 40-year low there will be an uptick in wage inflation – a different type of inflation. The MPC said in its notes: “Unemployment is low and projected to fall a little further…a small margin of excess demand emerges by late 2019 and builds thereafter, feeding through into higher growth in domestic costs than has been seen over recent years.”
Cazenove Capital’s view is that rates will continue to rise gradually. We do not expect real interest rates (the difference between interest rates and prevailing inflation) to reach the levels in the period before the financial crisis of 2008-2009.
In its commentary alongside the decision to increase the rate to 0.75%, the MPC stated: “Any future increases…are likely to be at a gradual pace and to a limited extent.”
The Brexit effect
Interest rates might have risen sooner, had it not been for the outcome of the EU referendum in June 2016.
Anxious about potential shocks to the economy arising from the decision to leave the EU, the Monetary Policy Committee responded by halving the Bank Rate from 0.5% to 0.25% in August 2016.
But subsequent economic growth was stronger than expected, and in November 2017 the Bank Rate was raised again to 0.5%.
Cazenove Capital sees Brexit as a key determinant for the pace of future policy measures including increases to the Bank Rate. If the UK avoids a "no-deal" or hard Brexit, the MPC may hasten the pace of rate increases (potentially making two further increases during the course of 2019), with the first rise coming in May 2019 after Brexit itself takes effect in March.
On the other hand, if we have a "no-deal" or hard Brexit, the Bank may delay further increases or even cut interest rates again.
What does the Bank Rate rise mean for mortgage rates?
Household borrowing costs – or mortgage rates - are related to the Bank Rate, but are influenced by other factors too.
There is a further difference between “new mortgage rates” – the rates offered to borrowers who take out a new deal – and the rates applying to existing loans. The latter rates tend to be more directly linked to movements in the Bank Rate.
With “tracker” mortgages, for instance, there is an explicit link between the rate the borrower pays and the Bank Rate. So for those “tracker” mortgage borrowers the latest 0.25 percentage point increase in the Bank Rate will translate into higher monthly repayments.
In the early phases of the financial crisis, a relative shortage of money for new mortgage lending meant that rates on new mortgages rose above the rates charged to existing borrowers. In recent years that trend has reversed and new borrower rates have fallen below those charged on existing mortgage stock.
Mortgage rates remain at very low levels. While rising rates are not helpful for consumers, the increases we envisage will not have a significant effect on households' financial sustainability.