Then, this morning, we have confirmation that the UK economy is continuing to recover. GDP grew by 0.6% in the first quarter of this year. This followed the technical recession in the second half of last year, when GDP contracted for two successive quarters, by 0.1% in Q3 and by 0.3% in Q4. Thus, the economy is rebounding from a weak level and therefore the year-on-year rise is still anaemic, up 0.2% from the first quarter of last year.
Nonetheless, as inflation eases, this should continue to boost real incomes and help growth. Much will then depend upon consumer and business confidence, both of which are recovering, consistent with steady economic growth over the course of this year. Of course, it’s always possible spending and investment plans may be put on hold as the general election approaches, because of uncertainty about what lies ahead. Yet, even allowing for this, the economy looks set to grow steadily this year, possibly around 1%, and next, when growth should be closer to 2%.
The service sector continued to lead the recovery in the first quarter, with services up 0.7%. Production was up 0.8% in the quarter, while construction fell 0.9%.
While economic recovery may, in itself, strengthen the case for the Bank not to cut rates, the reality is that decelerating inflation, and current tough monetary conditions suggest that there is scope for monetary policy to be eased. But this background also fits with our narrative that, while interest rates can fall, they should settle at relatively higher levels than pre-pandemic. The neutral level of interest rates should, in my view, be in line with the growth in money GDP. So, if growth is 2% and inflation 2%, then money GDP would be growing around 4% and that is where policy rates would likely need to settle.
Of course, the danger about keeping rates at 5.25% is that it may lead current tough monetary conditions to persist, dampening the pace of recovery.
Yet economic recovery itself does strengthen the case for the Bank to not ease prematurely. The next meeting of the MPC is in June, by which time there will have been two sets of monthly economic data. In particular, these should confirm that inflation has decelerated further and, in our view, to below the 2% target. Annual inflation fell from 3.4% in February to 3.2% in March and, according to the MPR, “is expected to return to close to the 2% target in the near term.”
Part of the challenge with monetary policy – and not just in the UK but in the US and euro area, too – is that it has become data dependent, and thus it is contingent and not forward looking. That is, naturally it is vital to take into account the latest monthly economic data, but at the same time one has to be mindful that monetary policy acts with a long and sometimes variable lag.
Thus, previous monetary policy tightening may still be feeding through, and this may be captured by sluggish monetary growth and tough financial conditions – including that many people remortgaging are facing significantly higher bills even though the market is contemplating rate cuts. Also, as the MPR noted, the Bank of England’s agents are “a little more downbeat on consumption and investment than in the previous reporting period”, but are still “cautiously optimistic” about growth over the course of the year.
Since the end of last year there has been a significant shift in market expectations about interest rates, particularly regarding the US, but this has also impacted thinking about UK rate cuts, too. Indeed, in recent months views about UK rates appear to have been driven often more by events in the US, rather than here. But as the Governor noted at the press conference, the inflation dynamics here are different to the US. It has been the case for some time, but even as long ago as 2022 the market seemed to view the US and UK in a similar vein, even though fiscal policies were materially different and with the US experiencing much stronger domestic demand.
While market expectations have shifted, we have stuck with our view about easing. We think the first cut will be in June, and that there should be two further reductions by year-end. This would leave policy rates at 4.5%. At the same time, we have reflected the shift in market thinking, and while we think rates should fall to 4.5% we have accepted that they may only be cut to 4.75%.
In the press conference the Governor implied not only that rates would fall, but that the market was not pricing in the extent to which they could fall. Yet he made clear that the decision regarding June was still open and that the MPC needed, “to see more evidence that inflation will stay low” before they cut rates.
To cut rates, I think that the MPC would need to be confident that core inflation was easing and that service sector inflation, which has eased but is still elevated, was lower, too. This would suggest domestic inflationary pressures are easing. Also, at the same time the MPC would need to be confident that while inflation appears set to rise in the second half of this year, that it will not rise too far, and subside in future. The latter is still uncertain.
The Bank sees inflation edging up in the second half of this year, to around 2.5% by the turn of the year, but then back to below the 2% target in the future, reaching 1.9% in two years and 1.6% in three. They noted three key medium-term judgements: that growth is picking up; that slack will emerge in the economy because of the restrictive stance of monetary policy; and that second round-inflation and wage pressures will take longer to ease than appear, and thus domestic inflation pressures persist for longer. Although, in terms of the latter, these second-round effects were expected to ease quicker than they previously thought. They may well revise these down again in future.
Also, it is worth noting that money does matter! Way back in 2017 I authored a piece both here – and in the Daily Telegraph – asking “What key economic work was not mentioned in the Bank of England’s (then) Inflation Report?” The missing word was “money”. Monetary developments, I argued, needed to be on the Bank’s dashboard and weren’t.
If they had monitored money properly, then inflation would not have risen as high as it did. Now, finally, it seems, the Bank is learning and it has moved from close to zero references to money in recent reports, to 65 mentions in yesterday’s MPR. That message now strengthens the case for gradual and early easing in interest rates.
But with growth recovering as well as inflation easing one can understand why the market is not yet certain when the first rate cut will come. The economy looks set for a disinflationary environment. As inflation eases, real incomes will rise, and this should contribute to a further steady improvement in the economy over the course of the year. I would also expect economic growth to accelerate further next year.
Please note, the value of your investments can go down as well as up.
