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.