The decision by the Bank of England's Monetary Policy Committee (MPC) to leave monetary policy and interest rates unchanged was not a surprise. But the vote underpinning the decision was. The vote was 5-3 in favour of unchanged policy, with three members of the committee opting for higher rates. The MPC has nine members but there is currently one vacancy. What does this tell us about policy?
It certainly implies that we are closer to a rate hike. But it does not mean one is imminent. The other five members may still vote to leave policy unchanged. The last time three members of the MPC voted to hike interest rates was May 2011, and rates have not risen but actually fallen since then. That being said, there are strongly conflicting pressures on the Bank and, while no change in rates is the most likely outcome in coming months, that is by no means clear-cut.
Rising inflation could test the Bank’s resolve
In announcing their decision, the MPC indicated that three factors would attract their attention: the evolution of inflation, how much consumption would slow and whether other components of demand would compensate.
Before the Bank had expected inflation to peak at 2.8%, but it is already higher than that, at 2.9%, and now it expects it to rise further, above 3% - prompting the Governor, Mark Carney, to write to the Chancellor explaining why. As we have previously written here, we thought inflation would peak around 3.5% later this year. If this happens it may test the Bank’s resolve.
Previously, the Bank felt domestic cost pressures would remain subdued. We agreed with this. This is key as it means that the current rise in inflation - largely driven by sterling's fall - would not persist. If domestic cost pressures - and in particular wages - remain subdued then inflation, after peaking later this year, would subside in 2018. Indeed, today the Bank said that, despite stronger employment growth, wage pressures remain subdued.
Much depends upon growth. The economy slowed to 0.2% growth in the first quarter (Q1). The Bank said today it expected 0.4% in Q2. Consumer spending is slowing but exports are doing well and, as the Bank noted, investment intentions are above historic averages. However, the hung Parliament and renewed political uncertainty may weigh on investment plans.
Perhaps the most telling comment today from the MPC was that, “The continued growth of employment could suggest that spare capacity is being eroded”, and thus, “reducing the MPC’s tolerance of above-target inflation”. In a nutshell, if the economy or employment growth does not slow then the MPC would decide to hike rates: better safe, than sorry.
No need to panic
Even if this happens there is no need to panic. Rates will rise gradually. One of the issues since last summer has been whether the Bank would seize the opportunity afforded by a weaker pound to rebalance policy by hiking rates. Indeed, when interviewed a few months ago the previous Governor, Mervyn King, said that the MPC often used to talk of the need for a weaker pound and higher rates. Perhaps now, finally, this is the direction of travel.
The world economy looks robust
While domestic factors are driving the Bank of England's thinking, it is worth putting this in a wider context. This week the US Federal Reserve raised interest rates again, despite slightly softer inflation and jobs data. Even though the UK economy has slowed recently, the world economy is looking more resilient and the issue of “policy normalisation” is being talked about more in the corridors of central banks around the world. Such normalisation means reversing quantitative easing and raising interest rates.
The US Federal Reserve has already started to normalise. The Bank of England has not yet moved this far but today’s vote shows that they are thinking about it. And when we, at Netwealth, consider client portfolios, so too must we.