The Bank of England Tells Us We Have a Supply-Side Problem

On Thursday, the Bank of England decided by a vote of 6-2 to leave interest rates unchanged at 0.25 per cent. They also opted to leave unchanged their other existing policy measures of £435 billion of government bond purchases and £10 billion of corporate bond buying. Changes to either of those, like any rate hike, would have marked a significant shift in the direction of policy and have had a market impact.

Despite leaving policy on hold it was the Bank of England's simultaneous release of its quarterly Inflation Report, with its update on the economy, that attracted attention and impacted financial markets.

In recent weeks, there has been a mixed but more hawkish tone on both the economy and interest rates from the Bank of England. Indeed, only a couple of weeks ago the Governor seemed upbeat. On Thursday, though, the mood was very dovish. Hardly surprisingly sterling weakened, as the Bank was accused in the market of sounding like a hawk and acting like a dove.

The Bank of England cut its economic forecast for both this year and next. We don't have an issue with their new forecasts. The Bank cut its 2017 growth forecast from 1.9 per to 1.7 per cent. We already know what happened in the first half of the year - and the Bank expects growth to be sluggish in the third quarter before recovering modestly in the fourth quarter. In 2018, it expects 1.6 per cent growth, which seems on the weak side but is plausible, and 1.7 per cent in 2019.

The prepared opening comments at the start of the press conference were distinctly pessimistic - and could easily impact market sentiment in coming weeks. Brexit, it seems, was blamed for everything. There is no doubt there are considerable near-term changes and these are not helped by the squabbling in the Government and uncertainty over aspects of Brexit policy. But even allowing for this, it was not until the one-hour press conference with the Governor that followed the release of their Inflation Report that some of the positives linked to the economy were raised.

There were four in particular to draw attention to. One, was the Bank seems convinced inflation will peak in coming months, so easing next year and thus allowing real incomes - that is income growth after allowing for inflation - to recover in 2018. Through this year the squeeze in real incomes has held the economy back, so reversing that trend would be good news.

Second was that the Bank expects consumer spending to grow in line with future income growth. This would imply no credit fuelled economic growth. In fact, when quizzed on this issue the Governor said the number of "vulnerable" households, paying more than 40 per cent of their income in debt payments had halved over the last five years to 1.25 per cent.

That leads onto the third positive, the Governor talked about future growth being driven more by investment and exports - which suggests that even though growth will be slower, it will be more balanced. And the fourth factor is the external environment, where the Bank alluded to firmer global growth - although, in my view, it may be even stronger than the Bank expects.

So even though the headlines were cautious, when we got into the detail the picture was more balanced. All of which leads us to remain constructive on the global outlook and believe that conditions will continue to be supportive of asset markets.

Perhaps more alarming was the Bank's longer-term projection of the economy. They now think investment will be weaker by 20 per cent in 2020 compared with what they expected it to be a year ago. This they felt would lower potential supply - and thus potential growth to just under 1.75 per cent per year. This is not good - but this is a deep-rooted problem, not new, highlighted by the Governor acknowledging that before the 2008 financial crisis they thought that this trend was around 2.25 per cent to 2.4 per cent. And since then there has been, in the words of Mark Carney, a "steady shaving of basis points" to this view of trend growth over that whole period.

In a nutshell, the problems underlying the Bank's long-term cautious view of potential growth are structural. They are not new because of leaving the EU but are linked to low investment and weak productivity. These may have been exacerbated by current uncertainty but they have been with us for years. That is why they need to be addressed, and it will take time to do so.

This has implications for interest rates. And it is an unwelcome message for the market to digest. In recent years the view from the Bank has been interpreted by the market as demand being too weak for policy to be tightened. This message was compounded with this week’s assertions that the weakening supply side of the economy means there is less spare capacity than the Bank previously thought. So, we have a supply side problem. The implication of this being that even if demand and growth do not pick up strongly the Bank may be forced to raise interest rates.

Amazingly I could not find the word "money" in the 52-page Inflation Report. Yet the growth of the money supply is always worth noting; it was growing at a steady pace last summer providing them another reason why economic collapse was unlikely. Now, in the last two months it has started to slow. The broad measure of money, M4, grew by an annual rate of 8.2 per cent in April, 6.7 per cent in May and 5.3 per cent in June, consistent with a more modest pace of economic growth.

UK Money Supply Growth

Source: Bloomberg

For now, the market believes rates are not set to rise anytime soon. This is our view too. Only a couple of hikes are expected by the market by 2020. The Bank indicated they think rates will rise more quickly than the market expects but they didn't say when. Yet, with the Bank now expecting wages to rise by 3 per cent next year, lower than they previously thought, and expecting domestic cost pressures to remain subdued, one can understand why the market has taken the view it has: policy will remain on hold for now.

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