Analysis of the BOE Interest Rate Decision

When it comes to forward guidance about the future direction of interest rates, or to making comments that might boost economic confidence, the Bank of England (BOE) leaves much to be desired. On Thursday the BOE’s Monetary Policy Committee (MPC) voted 7-2 to leave interest rates unchanged at 0.75%.

Given the post-election rebound in economic confidence, such a decision was probably the right one. However, in recent weeks the MPC had led the market to believe a cut was very possible. Yet, even though the Bank did not cut rates, their revised economic forecasts were very downbeat, as too were the comments from The Governor to accompany them.

If anything, given their increased economic pessimism, the Bank should have cut rates. Their forecasts hardly suggest they expect the post-election bounce in the economy to be sustained. Moreover, given the importance of confidence in any economy, this hardly seems likely to be boosted by the Bank’s forecasts and messaging. Low expectations can become self-fulfilling, restraining confidence.

Following its own path

Last year, the Bank did not join the large number of central banks across the world who eased. Although policy rates are low, the last few years have seen steady, sometimes incremental, tightening by the Bank, as we have alluded to before: lending schemes retired, printing of money stalled, rates hiked incrementally and the counter cyclical capital buffer raised. The Bank cut its forecasts for economic growth for this year, 2021 and 2022, versus its previous forecasts made last November. Last year the economy grew 1.25%.

The Bank expects only 0.75% this year, 1.5% next year and 1.75% in 2022. It also sees inflation at 1.5% this year but, despite the weak growth profile, expects inflation to rise to 2% next year and 2.25% in 2022.

While it sees the economy as having spare capacity this year, in terms of an output gap, it sees this then disappearing, in turn exerting upward pressure on inflation. In essence, its view is that the economy’s growth capacity is low; at least this is consistent with the Bank having cut its view of trend growth since the aftermath of the 2008 financial crisis.

Given that, a legitimate question can be raised as to whether the Bank has asked enough of the right questions on whether it should have, or could do more, to boost the supply side of the economy. Should there not be a more active discussion about sluggish bank lending? Monetary growth, too, has been sluggish, although it has picked up recently.

The right policy outcome for the wrong reason?

Of course, the Bank could be correct – or even, as we suspect, may be too pessimistic about this year’s growth outlook. But that is not the point. Based on their forecasts of only 2.25% growth in nominal GDP (growth of 0.75% plus inflation around 1.5%) they should have eased. But, as noted, given the recent economic bounce, they may have achieved the right policy outcome, for the wrong reason.

The challenge about a weak trend rate of growth is a very real one for the government. If the economy were to hit what they see as the relatively low trend rate of growth, the Bank would then be in danger of tightening prematurely. Also, if similar analysis were applied to the Treasury’s thinking behind the forthcoming Budget then more of the budget deficit would be seen as structural, as opposed to cyclical, and this would limit the potential room for fiscal stimulus. The economy clearly needs a fiscal boost in this March Budget, as the markets are expecting.

Low rates are here to stay

Of course, there is the Brexit negotiations. This adds a further degree of uncertainty, impacting potential investment and hiring decisions. Greater clarity from the government would naturally help. Even though the Bank’s actions on Thursday boosted sterling, the likelihood is that the prospect of rates staying low for long should ensure the pound remains competitive.

Overall, interest rates still look set to remain low. If they were to move anytime soon, it would be down. But, in all likelihood, rates appear set to stay low and stable, with the policy stimulus coming from the fiscal side.

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