November 2, 2017 may go down as a historic day: it could be the first time in 3,773 days that the Bank of England raises the base rate. Of course, this is not the first time that the Bank or markets have expected a hike, but this time really does seem different.
Chart 1: The Bank of England (BoE) has failed to deliver before…
Source: Bloomberg
Uncharted Territory
Should the BoE hike, the market reaction is uncertain. The fact that many traders and investors have never seen base rates rise in the UK – something often discussed in the media, such as here – could add to the drama. Complicating matters further is that some economists think that the Bank could be making a mistake; more on this later. Coming back to a lack of experience surrounding monetary tightening, a fun fact: Mark Carney, as Governor of both the Bank of Canada from 2008 to 2013, and at the Bank of England since he joined in 2013, has never presided over a rate hike (although during his time as deputy Governor at the BoC, the Bank did raise rates).
Markets are almost certain that a hike is coming
The probability implied from interest rate products is around 85% at the time of writing, and indeed, BoE staff have indicated as much – one of the reasons that traders are so confident.
Many questions remain
Do we agree with the market’s assessment? And would it be, as many suggest, a policy error? Why would the BoE be hiking, and why has the Monetary Policy Committee (MPC) changed their outlook so suddenly? Will it be a so-called “one-and-done”, or could this be the beginning of a more traditional hiking cycle? In this blog, we look to answer some of these questions.
The short answer
I expect the BoE to hike next month – mostly, because they have told the market as much. The question of why the BoE is hiking and what has changed is the most interesting one: in terms of economic data, not much has changed, and both wages and growth have remained disappointing. Inflation is of course above target, but much (if not all) of the increase has come from the currency effect, which will begin to drop out of inflation. It seems to us that the BoE’s reaction function has changed somewhat. A hike at this stage could be an error, but if inflation begins to fall this year as simple base effects would suggest, and if wage growth rebounds to anything remotely close to what the BoE expects, then a 0.25% hike would be relatively painless over the short to medium term.
As for the future, the MPC has indicated that further hikes could be warranted in the coming years as well, but we doubt that they will materialise.
Investors have been preparing for this moment since the summer
A November hike has been on the cards since the BoE meeting in mid-September, where the committee indicated in its statement that “some withdrawal of stimulus is likely to be appropriate in the coming months”. This was followed by a number of BoE speeches backing this up, including great ones from Carney, and Vlieghe, here and here. Since then, a number of economic data releases have turned out much as expected: the UK economy is doing okay, but not great.
Chart 2: Probability of hike by November 2017
Source: Bloomberg
Last week, Mark Carney, Sir David Ramsden and Silvana Tenreyro testified in front of the Treasury Select Committee. If they are not looking to hike next month, this was their chance to set the markets straight, but they chose not to do that. Nor, however, did they specifically confirm a November hike, and there is more uncertainty than many think: Ramsden, the newest member of the MPC, but a Treasury veteran, indicated the he is not part of the majority that think a hike in the coming months is warranted. Meanwhile, Tenreyro, the least known member of the MPC, stressed that her vote is dependent on the data, and that a hike might be warranted in the coming months, rather than next month.
November will not be unanimous, and the hike could in fact come in December instead – if the data holds up, of course. It is not a done deal just yet.
Is the Bank about to make a policy error?
A growing number of economists, researchers and organisations have recently voiced their objections about the intended rise in interest rates; just recently, for example, the British Chamber of Commerce said it would be “extraordinary” for the BoE to consider hiking in current times.
A number of different arguments are made, but first and foremost is the lack of domestically driven inflation pressures – i.e. weak wage growth, something the BoE itself frequently mentions. Inflation is above target, but will fall off naturally, based on just base effects. Indeed, the BoE expects Consumer Price Index (CPI) to peak in October at current levels of 3.0% and then begin to fall back. At the same time, while a solitary 0.25% hike may not be enough to significantly slow the UK economy, consumers would extrapolate the hike further into the future. Markets have already begun to do this: 5y Gilt yields in the UK rose by around 0.50% following the BoE statement in September. This is important because currently around half of UK mortgages are on a fixed rate; the average fixed term is around 4 years. A 5-year fixed rate mortgage will be priced off the 5-year rate, and so a 0.25% hike could ultimately have much bigger impact on mortgage rates. In 2017, the UK economy is expected to grow by only 1.5%, its weakest performance since 2012, and 2018 is forecasted to be even lower1. Lastly, the political uncertainty (both domestic politics and Brexit) is not helping matters. This does not appear to be an economy at risk of overheating.
Chart 3: Chart of the week: The PMIS are well below rate hike levels
Source: Pantheon Macroeconomics.
So why is the BoE adamant on hiking?
“I believe that the more you know about the past, the better you are prepared for the future.” Theodore Roosevelt
In our case, we only need to look into the recent past, to June, and the release of the BIS Annual Report. The report highlighted increasing risks relating to financial stability from continued easy policy, and also suggested that central banks could look to normalise rates while they had the opportunity. To many, it was thus not a coincidence that various central banks globally shifted their rhetoric from a dovish to a hawkish bias. Notably, the BoC and the BoE, whose governors commanded some of the most dovish reputations in the market, were two of these banks. Since then, the Canadians have hiked twice, but the UK is yet to follow.
Co-ordinated or not, we believe that central bank reaction functions may have changed: perhaps to less of a focus on inflation in the short run, and more focus on financial stability. In addition, with global growth improving in a synchronised fashion, central banks appear more confident that the ever elusive wage gains and higher inflation prints are just around the corner. Each central bank also has their own particular issues to deal with: the ECB, for example, faces technical constraints to Quantitative Easing (QE), which are surely encouraging Draghi to begin tapering, even as inflation remains well below target (and is likely to fall back to around 1.0% early next year).
The UK faces a different set of issues, primarily a weak pound, which has driven inflation higher in the UK. In the absence of strong wage growth, the fall in real incomes continues to have negative consequences for UK consumers, and has been regular front page news in the UK.
Currency weakness: not all it’s made out to be
It has been somewhat of a double-edged sword for the UK when it comes to the currency: the weaker pound has not helped to improve the current account deficit as much as was expected, while the negative effects of higher import costs have been greater than many expected. Although the BoE would not admit this, it is possible that strengthening the currency is part of their strategy. A paper written by Kristin Forbes (who has since left the MPC) suggests that sterling is a key driver of inflation dynamics in the UK, and not just a temporary factor, as it is currently regarded by policy makers. It provides an academic basis to act based on currency movements. It would follow, then, that hiking rates, assuming that it leads to a stronger pound, would be less negative for the economy than perhaps expected.
Brexit
The BoE assumes a “smooth adjustment to trading arrangements” with the European Union, and we believe markets are currently pricing in a “soft” Brexit and a lengthy transition period – an outcome that looks increasingly less likely; ever more, we are hearing of more discussions of “no deal” and World Trade Organisation (WTO) arrangements. Such a scenario is unlikely to flare up in the coming weeks, but early 2018 could be a different story. UK companies have been patient so far, but in January, with just over a year until the UK leaves the EU, companies will be forced to start making decisions about future operations and investments. Some, of course, have already begun.
Whatever one’s opinion about the merits of Brexit, it seems clear that markets would react extremely negatively to a “no deal” scenario – and the BoE, in such a scenario, would be more likely to be easing policy than tightening it.
Conclusion
The Bank of England has in essence committed itself to a hike in the near future – and it is very likely to be next month. The future path, however, is more ambiguous: whether the BoE plans to hike more or not, we think a large number of headwinds may stop them from doing so.
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1 Source: Bloomberg Economic Forecasts
Links
https://www.wsj.com/articles/juniorization-when-young-workers-replace-the-old-1466184588
http://www.bankofengland.co.uk/monetarypolicy/Pages/decisions.aspx
http://www.bankofengland.co.uk/monetarypolicy/Documents/externalmpc/extmpcpaper0049.pdf
http://www.bis.org/publ/arpdf/ar2017e.htm?m=5%7C24
http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech995.pdf
http://www.bankofengland.co.uk/publications/Pages/speeches/2017/996.aspx
