Bank of England: Predictably Unpredictable

At the end of April, on these pages I commented "If it was my decision, I would be tempted to leave rates on hold in May, as inflation is falling, growth is sluggish and sterling has recently strengthened." Today the Bank of England announced their rate decision, alongside their latest read of the economy.

The Bank decided by a decisive vote of 7-2 at its May meeting to leave rates unchanged at 0.5 per cent. They also cut their growth forecast for 2018 from 1.8 per cent to 1.4 per cent following weak first quarter economic figures. But with rates so low the Bank still has a bias to raise rates, although it is clear that they are in no rush to do so.

Of course, you could be forgiven if you felt unsure about the Bank’s messaging. At times it has been far from clear. In recent weeks financial markets lowered their expectation of a rate hike in May, having previously been led by the Bank to think one was almost certain.

Whereas the US Federal Reserve’s experience with “forward guidance” - whereby the central bank tries to guide the markets and the general public about the future direction of rates - has been a success, the Bank of England’s has left a lot to be desired.

The impression one gets from the US is that the authorities would like higher rates because the economy is stronger, so they would like to keep inflation in check - but also they feel the need to get rates to a higher level in case they need to ease in response to an eventual slowdown. The latter goal was a common theme among policy makers in recent years.

Here, in an interview with the previous Governor Mervyn King in 2016, it was interesting to note his comment that the Bank during his time had often discussed how to achieve the mix of cheaper pound, higher rates and lower house prices. Perhaps it may have been possible to have edged towards this in recent years. But not now.

Despite the uncertainty about what could happen at today’s meeting, for some time now the messaging from the Bank has been that rates will stay low, rise gradually and peak at a low level. For the Bank, the new message is that they need to see much firmer data first. This is an important consideration for UK markets.

On a few occasions I have written in the press that the Bank need not move rates in quarters of percentage points. With rates at such low levels, even smaller hikes can have meaningful effects on borrowers, broader economic behaviour and financial markets. My suggestion was to move in one-eighths of a point (0.125% rather than 0.25%). Certainly, as we have outlined, moves should be gradual and predictable.

But what of the economy? Just as I have often been surprised at how optimistic views about the economy have been in the past - it is very unbalanced as the financial crisis highlighted - I now feel the consensus has shifted to the other extreme. There is far too much pessimism. Some of this may largely reflect the uncertainty with leaving the European Union and the apparent inability of the Government to make concrete decisions on some of the basic issues - like the customs union - approaching two years after the referendum.

Given the outlook for the economy depends upon the interactions between the fundamentals, policy and confidence, it would not be a surprise if what I have described above has weighed on investment intentions and spending plans.

In the first three months of the year the economy grew only 0.1 per cent on the previous quarter. Weather took its toll, although the official statistics office said the impact was limited. However, construction activity looks particularly weak and house price inflation has slowed.

Of course, it is not just interest rates. Other aspects of policy impacting banks and lenders - such as macro prudential and regulatory policy - may also be weighing on lending decisions. Money supply growth has decelerated significantly over the last year from an annual growth rate above 8 per cent last April to 2.2 per cent this March. Also, it was interesting to note that unsecured consumer credit rose by only £254 million pounds in March, the lowest since November 2012.

There are so many conflicting economic messages. The employment data is strong. Indeed, in our view consumer spending should benefit over the remainder of the year from a deceleration in inflation and a further gradual rise in wage growth. Also, exports should gain from solid growth in world trade. While the UK economy is heavily oriented to service sectors, manufacturing growth has been solid. If so, the economy should pick-up in the second quarter and grow above 1.5 per cent this year.

Overall, a key issue we have stressed is the need for central banks - worldwide - to tighten gradually and predictably. The Bank of England may not have been predictable, but it certainly looks set to be gradual in its interest rate decisions.

Although the Bank decided to lower their growth forecast for 2018 to 1.4 per cent they have not changed their longer-term view of economic growth of around 1.75 per cent in future years. Markets may be content with such a pace, given recent pessimism, however the Bank believes the economy’s potential growth rate is only 1.5 per cent, hence their view that they will need to hike at some stage.

Surprisingly, perhaps, the Bank believes it will take two years for inflation to fall back to its 2 per cent target. That seems too long, with inflation now at 2.5 per cent. With the labour market so tight, the Bank and the markets may focus increasingly on what is happening to wages in coming months.

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