Economic Update
Financial markets are entering what could be a potentially tricky time. In addition to the continuous flow of new economic data and company results across the globe, the coming weeks are likely to see potentially critical moments in a host of issues. Let’s start here in the UK.
On Thursday 2nd August the Bank of England releases its next quarterly Inflation Report and its Monetary Policy Committee (MPC) is expected to raise interest rates from 0.5% to 0.75%. It is by no means clear-cut that the Bank should raise rates, as growth is far from strong and inflation is decelerating.
Even if they do raise rates, I believe they should move in small steps of 0.125%. That, however, seems unlikely. Having backed away from hiking on a number of recent occasions, the Bank now appears less worried about downside risks to the economy and keener to normalise monetary policy. Thus, a hike is widely expected.
Rate hikes: slow and steady is expected
The underlying message in recent years has been that rates will stay low, rise gradually and peak at a low level. After this meeting rates will still be low, even if they increase, and are only rising gradually. The Bank is also expected to provide some insight this week into the level at which rates may peak, announcing where they see the equilibrium interest rate – or r* (r-star). The idea of an equilibrium interest rate is common in economics and in US policy making circles but is new to UK policy making.
The idea is to have a benchmark interest rate that will drive thinking and expectations. Effectively it is the interest rate needed to achieve the 2% inflation target while the rate of unemployment is at a natural rate, effectively meaning the economy is growing at a solid pace. It implies more balance to interest rate decisions, rather than a focus on achieving sorely the inflation target, although in reality this is how the MPC appears to have behaved anyway. Trouble is, the idea of the eliquibrium rate is far more fluid than it sounds, and over recent decades r* has fallen significantly. Thus, in the future, it will move too.
The likelihood is that their current r* will be slightly above where rates are now, perhaps around 1.0%, reflecting that monetary policy has been accommodating with rates low and that the labour market is now tight.
The question is where should r* be in the future? The current debate in the market is whether a future r* in coming years will show a peak in the range of 1.5% to 2.5%, signalling a gradual tightening. The markets should take this likely debate in their stride, although naturally there will be much attention on how the economy - and the markets - will cope with higher rates.
The challenge for all central banks – including the UK – is to move gradually, both on raising rates and on reversing their previous quantitative easing. The Bank’s policy consists of a 0.5% base rate, £485 billion of quantitative easing and holding £10 billion of corporate bonds. While monetary policy has been accommodative, regulatory policy has been tougher, and has taken some of the heat out of the housing market, but also has potentially held back economic growth.
An imbalanced UK economy, but many positives
The UK economy suffers from being heavily imbalanced, but many of these issues are deep rooted, and cannot be addressed by keeping interest rates at 0.5% or moving them to another level.
Notwithstanding those imbalances, the economy is showing many positives: growth recovered in the second quarter (April to June), when it looks to have grown 0.4% after the weather-related weakness of only 0.2% growth in the first quarter; the budget deficit continues to fall at a faster pace than the markets expect – something we have stressed is likely, on a number of occasions, as the growth of nominal GDP continues to outstrip the interest rate paid, and as tax revenues grow at a faster pace than government spending; and the current account deficit has fallen significantly recently but is still sizeable. Employment is at a record high, yet wage growth is modest. In turn, inflation has decelerated to 2.4%.
Sterling, however, remains weak. This is welcome in our view, given the need for large parts of the UK economy to become more competitive, and given the modest nature of inflation. The chief challenge, therefore, is the political uncertainty.
Political uncertainty still casts a long shadow
We are entering another critical stage of the UK’s exit negotiations with the EU. The Government has released a White Paper outlining its latest thinking; often referred to as the Chequers Plan. This still needs to be agreed with the EU and approved by Parliament for it to become effective.
Given this path, and the criticisms already levied at this plan, three options are seen as lying ahead. First, significant further concessions to the government’s proposal. This would move the UK towards a Norway-style relationship with the EU, where it is a rule-taker. In the short term the markets may like this, as it would imply both a transition deal to the end of 2020 and a close relationship with the EU. However, it would severely constrain further domestic economic policy as well as the UK’s ability to conduct global trade deals. Notwithstanding the economic cost of this, there would likely be further political turbulence.
As a result, the other two options are likely to receive increased scrutiny over the summer: these are an enhanced free trade agreement (often referred to as ‘Canada plus’, but it is in fact far more than that) and the World Trade Organisation deal (also often referred to as ‘No deal’).
Similar themes also prevail outside the UK
Meanwhile, outside the UK, financial markets elsewhere are contending with similar themes: the prospect of monetary tightening, led by the US, but now also being talked about in Japan and the EU; and the uncertainty around geopolitical events, largely linked to US foreign policy. With US yields at attractive levels the dollar is the potential beneficiary, but if policy is tightened elsewhere then there may be increased currency volatility elsewhere, too.
The tit-for-tat approach to trade frictions between China and the US has already alarmed markets. In turn the latest news regarding potential EU-US trade tariffs was not as bad as feared. To coincide with the recent G20 meeting in Argentina, the IMF provided an update on their view of the world economy. It tallies with ours. After growth of 3.2% in 2016 and 3.6% last year, they see 3.9% growth this year.
However, their scenarios showed that growth could be hit by 0.4% to 0.5% if trade tensions escalated, with the US suffering most. This may yet deter the pace, but not the direction, of US monetary policy tightening. In turn, it has, as we have seen this week, encouraged the Chinese authorities to ease policy, through a combination of monetary and fiscal easing.
After signs of a slowdown in the second quarter in China, such a stimulus is welcome news for the Chinese economy and, importantly for markets, may ease some of the downward pressure on the Chinese currency. The fact that the Chinese have the ability to ease monetary policy in the face of potential worries will not go unnoticed by central banks in the west, who feel that they need to normalise policy to create room for future policy manoeuvres.
It is a conundrum facing the policy makers. For the markets it is just one of many issues that need to be assessed over coming months.
On Thursday 2nd August the Bank of England releases its next quarterly Inflation Report and its Monetary Policy Committee (MPC) is expected to raise interest rates from 0.5% to 0.75%. It is by no means clear-cut that the Bank should raise rates, as growth is far from strong and inflation is decelerating.
Even if they do raise rates, I believe they should move in small steps of 0.125%. That, however, seems unlikely. Having backed away from hiking on a number of recent occasions, the Bank now appears less worried about downside risks to the economy and keener to normalise monetary policy. Thus, a hike is widely expected.
Rate hikes: slow and steady is expected
The underlying message in recent years has been that rates will stay low, rise gradually and peak at a low level. After this meeting rates will still be low, even if they increase, and are only rising gradually. The Bank is also expected to provide some insight this week into the level at which rates may peak, announcing where they see the equilibrium interest rate – or r* (r-star). The idea of an equilibrium interest rate is common in economics and in US policy making circles but is new to UK policy making.
The idea is to have a benchmark interest rate that will drive thinking and expectations. Effectively it is the interest rate needed to achieve the 2% inflation target while the rate of unemployment is at a natural rate, effectively meaning the economy is growing at a solid pace. It implies more balance to interest rate decisions, rather than a focus on achieving sorely the inflation target, although in reality this is how the MPC appears to have behaved anyway. Trouble is, the idea of the eliquibrium rate is far more fluid than it sounds, and over recent decades r* has fallen significantly. Thus, in the future, it will move too.
The likelihood is that their current r* will be slightly above where rates are now, perhaps around 1.0%, reflecting that monetary policy has been accommodating with rates low and that the labour market is now tight.
The question is where should r* be in the future? The current debate in the market is whether a future r* in coming years will show a peak in the range of 1.5% to 2.5%, signalling a gradual tightening. The markets should take this likely debate in their stride, although naturally there will be much attention on how the economy - and the markets - will cope with higher rates.
The challenge for all central banks – including the UK – is to move gradually, both on raising rates and on reversing their previous quantitative easing. The Bank’s policy consists of a 0.5% base rate, £485 billion of quantitative easing and holding £10 billion of corporate bonds. While monetary policy has been accommodative, regulatory policy has been tougher, and has taken some of the heat out of the housing market, but also has potentially held back economic growth.
An imbalanced UK economy, but many positives
The UK economy suffers from being heavily imbalanced, but many of these issues are deep rooted, and cannot be addressed by keeping interest rates at 0.5% or moving them to another level.
Notwithstanding those imbalances, the economy is showing many positives: growth recovered in the second quarter (April to June), when it looks to have grown 0.4% after the weather-related weakness of only 0.2% growth in the first quarter; the budget deficit continues to fall at a faster pace than the markets expect – something we have stressed is likely, on a number of occasions, as the growth of nominal GDP continues to outstrip the interest rate paid, and as tax revenues grow at a faster pace than government spending; and the current account deficit has fallen significantly recently but is still sizeable. Employment is at a record high, yet wage growth is modest. In turn, inflation has decelerated to 2.4%.
Sterling, however, remains weak. This is welcome in our view, given the need for large parts of the UK economy to become more competitive, and given the modest nature of inflation. The chief challenge, therefore, is the political uncertainty.
Political uncertainty still casts a long shadow
We are entering another critical stage of the UK’s exit negotiations with the EU. The Government has released a White Paper outlining its latest thinking; often referred to as the Chequers Plan. This still needs to be agreed with the EU and approved by Parliament for it to become effective.
Given this path, and the criticisms already levied at this plan, three options are seen as lying ahead. First, significant further concessions to the government’s proposal. This would move the UK towards a Norway-style relationship with the EU, where it is a rule-taker. In the short term the markets may like this, as it would imply both a transition deal to the end of 2020 and a close relationship with the EU. However, it would severely constrain further domestic economic policy as well as the UK’s ability to conduct global trade deals. Notwithstanding the economic cost of this, there would likely be further political turbulence.
As a result, the other two options are likely to receive increased scrutiny over the summer: these are an enhanced free trade agreement (often referred to as ‘Canada plus’, but it is in fact far more than that) and the World Trade Organisation deal (also often referred to as ‘No deal’).
Similar themes also prevail outside the UK
Meanwhile, outside the UK, financial markets elsewhere are contending with similar themes: the prospect of monetary tightening, led by the US, but now also being talked about in Japan and the EU; and the uncertainty around geopolitical events, largely linked to US foreign policy. With US yields at attractive levels the dollar is the potential beneficiary, but if policy is tightened elsewhere then there may be increased currency volatility elsewhere, too.
The tit-for-tat approach to trade frictions between China and the US has already alarmed markets. In turn the latest news regarding potential EU-US trade tariffs was not as bad as feared. To coincide with the recent G20 meeting in Argentina, the IMF provided an update on their view of the world economy. It tallies with ours. After growth of 3.2% in 2016 and 3.6% last year, they see 3.9% growth this year.
However, their scenarios showed that growth could be hit by 0.4% to 0.5% if trade tensions escalated, with the US suffering most. This may yet deter the pace, but not the direction, of US monetary policy tightening. In turn, it has, as we have seen this week, encouraged the Chinese authorities to ease policy, through a combination of monetary and fiscal easing.
After signs of a slowdown in the second quarter in China, such a stimulus is welcome news for the Chinese economy and, importantly for markets, may ease some of the downward pressure on the Chinese currency. The fact that the Chinese have the ability to ease monetary policy in the face of potential worries will not go unnoticed by central banks in the west, who feel that they need to normalise policy to create room for future policy manoeuvres.
It is a conundrum facing the policy makers. For the markets it is just one of many issues that need to be assessed over coming months.
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