Yesterday, for the first time in more than a decade, the Bank of England Monetary Policy Committee voted by a majority of 7-2 to raise UK interest rates by a quarter point, from 0.25% to 0.5%. It was a move that has been well signalled by the Bank in recent weeks and thus it was widely expected by the market.
Source: Bank of England
The rate decision also coincided with the release of both the Bank’s quarterly Inflation Report and press conference. Here are some key takeaways:
- The Amendment to the Statement: the immediate market reaction that saw the pound weaken was heavily influenced by a significant removal of wording from the monetary policy statement. The August summary stated that, “All MPC members continue to judge that, if the economy follows a path broadly consistent with the August Inflation Report central projection, then monetary policy could need to be tightened by a somewhat greater extent over the forecast period than current market expectations” (our emphasis in bold). However, this was absent from November’s summary, suggesting that the market’s current pricing for future interest rates is not too different to that of the Bank’s rate setters. This is worth emphasising as the market expects short term rates to reach only 1% by the end of 2020, i.e. pricing only two more hikes over the next three years. Although Governor Carney said that the additional 2 hikes ‘doesn’t quite get there, and the economy is likely to be in a position of excess demand,’ the message clearly was that the rate hiking cycle was going to be slow and gradual.
The Renewed Caution About Growth: three months ago, during the press conference, the Governor acknowledged that the Bank had been lowering their view of trend growth over the last decade. Today, he reaffirmed that expectation for lower potential GDP growth. Moreover, his message was that with subdued productivity growth and low levels of spare capacity in the labour market it is likely that the modest growth numbers seen in recent years are in fact closer to the future norm. The historical pre-crisis growth rates, when productivity growth was higher are likely to be a thing of the past. The implication of this, in our view, is mixed for rates: it suggests that the economy may encounter inflation at lower future rates of growth than in the past, while at the same time it implies we should not expect very strong growth either. That being said, the Governor did acknowledge growth could be above this trend in the near-term. This would imply that the data - not a predefined view - will determine how the Bank moves on rates.
The Brexit Effect: while the lowering of potential GDP is a structural phenomenon that has been playing out since the financial crisis, this has been reinforced by Brexit. In the near term the Bank notes, ‘the decision to leave the European Union is having a noticeable impact on the economic outlook’ through uncertainties negatively impacting investment, the pass through of the weaker currency on inflation and the consequent squeeze on households’ real incomes.
The Number of Dissenters: two members of the nine-person committee voted against an increase in rates, noting that they wanted to see more evidence of domestic costs picking up before raising rates. Six members of the committee voted against a rate rise in August. Perhaps conviction in this decision wasn’t definitive and may be questioned if data were to weaken significantly.
The General Tone: today’s communication illustrated a gloomy outlook and did very little to highlight some of the more positive data seen this year. It is worth remembering that the economy has fared much better than was expected in the aftermath of last year’s referendum; unemployment is at a 42-year low and GDP growth is steady, albeit at a slower pace than other developed market counterparts.
Today’s announcement should have a mild positive impact on portfolios, with those at the lower end of the risk spectrum, with higher fixed income allocations, benefitting from the decline in gilt yields that resulted from the more dovish tone. Additionally, the higher risk portfolios would have been bolstered by the unhedged international equity exposure, which benefits from the translation of the weakening of the pound, despite muted returns in local currency terms.
The next UK centric event in the calendar is the budget announcement on the 22nd November and more details can be found on our current thoughts about the UK economy here, but in the interim we will continue to assess the economic and policy outlook, as well as the impact of today’s decision on asset markets and portfolios.