Monetary Policy Normalisation

Monetary policy normalisation: this is the key issue that will influence heavily the investment outlook. In the wake of the 2008 global financial crisis, central banks played a dominant role as they pumped in money and cut interest rates. Now, as they exit from their cheap money policies, central banks will have an equally important influence on how financial markets and currencies perform – both here in the UK and overseas. The exit strategy will vary from country to country, depending heavily on domestic economic conditions. It is being led by the US, which embarked upon its tightening a few years ago, and followed by other major central banks at varying speeds.

On Thursday – as expected by the markets – the Bank of England raised Bank Rate by 0.25% from 0.5% to 0.75%. The decision was unanimous, with a 9-0 vote. This hike should have limited impact on the economy or markets. The key is what happens from here.

Our read of the Bank’s quarterly Inflation Report is that it does not change our view of the economy or of the Bank’s likely actions. We would summarise the key message as this: rates will be low, rise gradually and peak at a low level.

Indeed, in this Report the Bank outlined their new “equilibrium interest rate”, which gives an insight into where they think interest rates are likely to settle, to keep inflation at its 2% target, alongside steady economic growth. Their “current estimate” is 2% to 3%. Hence, as they state in their Report, “Any rises in Bank Rate are expected to be limited, and interest rates are likely to remain low by historical standards for some time to come”. In fact, the Governor, speaking on the radio on Friday morning, implied that rates may rise only 0.25% a year, for each of the next three years. Although this was not an official forecast, it reinforced the message that rates will stay low.

Interest rates are expected to rise gradually

Source: Bloomberg

Reading the economy

The Bank’s read of the UK economy is in line with our assessment. In essence, it is a mixed economic picture. On the positive is that economic growth has recovered from a weak first quarter of the year when it was hit by poor weather. Between January and March the economy grew by only 0.2% versus the previous quarter. The Bank expects data to show a rebound to 0.4% in the second quarter. They expect this to be sustained so that by the last quarter of this year the annual rate of growth will have risen to 1.75%. The downside is that this pace of growth is still subdued. It helps explain that, while interest rates are low compared with the past, there is no need to expect them to be high now, especially as inflation is decelerating too.

The Bank will really need to assess how the economy copes with this rate increase, as small as it is. Within their Report, the following observations fitted with the idea of steady growth in the future. Demand for lending by small firms has risen, having previously been weak. Housing market weakness has been concentrated in London, not elsewhere. Average weekly earnings rose by an annual rate of 2.7% in the three months to May, versus 2% a year ago, and it was noted that those who were switching jobs were now seeing wage growth returning to pre-crisis rates. Higher income growth was seen as sustaining consumption.

Also, the Bank’s future behaviour will also not just be guided by the resilience, or otherwise, of the economy, but by the outlook for inflation. And in this context wage behaviour, and the impact it has on domestic inflation pressures, is key.

They note that unit labour costs, which are another guide to potential inflation pressures, continue to rise, albeit from low levels. This reflects that costs and wages are rising compared with productivity. Between 2010-15 unit labour costs rose by 0.5%, by 2015 they were rising by 1.75% and now the Bank sees them rising 2.25%. It fits with the Bank’s thinking that there is little spare capacity in the economy.

This suggests the Bank will have a bias to tighten further, although they should be in no rush to do so. After all, there is still considerable uncertainty about policy, particularly with regards to Brexit, and how this will impact the economy and sterling. While the Bank does not have a policy towards sterling, our feeling is that it is fairly valued for now, although it could soften versus the dollar, especially as US rates head higher.

Other policy levers

In addition to interest rates there are other levers of monetary policy that one needs to keep an eye on, and the Bank must not tighten too much in these other areas. For instance, the Financial Policy Committee has already announced that counter cyclical capital buffers will increase later this year, thereby tightening by dampening banks’ ability to lend. In addition to this, when will the process of quantitative easing (QE) that led to the printing of money be put into reverse? The Bank of England’s quantitative easing has seen its holdings of government bonds remain at £435 billion for some time now, and its holding of corporate bonds is £10 billion, both financed by the issuance of central bank reserves. One would hope that quantitative tightening will not happen for some time, but if not, then this would present another challenge for financial markets.

Household wealth

Finally, it is worth reflecting on how the Bank views the household balance sheet. Although borrowing on credit cards and the level of outstanding household debt are high and sending warning signals, the overall message is that the household balance sheet is in good shape, as assets rise at a faster pace than debt. Of course, there will be distributional effects, with those holding the debts possibly different to those with the assets. “Since the crisis, net financial wealth has risen by around 60%, credit conditions have loosened, unemployment has decreased, and the savings ratio has fallen .... to historically low levels.” Housing wealth has increased too, up 40% since the crisis and 12% from the end of 2015. This favourable environment, for assets and wealth, has been helped by the cheap money policy of the Bank of England, and of central banks elsewhere. Now, as rates rise, this backdrop may become more challenging.

Market impact

Financial markets had already priced in this change in interest rates – so there was little immediate impact, coming as it did at the end of a busy week of central bank communication from around the world. Initial surprise about the unanimous support for a hike within the MPC boosted sterling, but this soon faded as the US dollar resumed its strength in an environment of broadly weak sentiment for risk assets. UK equities were also weaker, but they were driven more by investor concern over the impact of trade conflicts on commodity-related stocks than by the Bank’s actions.

Looking forward, markets continue to place a significant political risk premium on UK assets, and signs of progress on a Brexit deal with the European Union will hold more weight for sterling than a small change in interest rates.

In our view, the key questions for global markets remain whether the widening gap between US economic growth – and the coinciding corporate earnings momentum - and other major economies will be sustained. Broader global participation in economic growth - through stronger growth rates outside the US - should deliver better relative performance from non-US cyclical assets. So far this year, these have been muted, although they now represent better value than the US as a result. Without it, the dollar could continue to strengthen and asset markets may see more volatility as a result.

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