More than a Turning Point? What the UK Interest Rate Rise Means

As the dust settles on last week's interest rate increase from the Bank of England, what are the implications? The day after the rate hike both the FTSE 100 and the 250 indices closed at record levels. The latter is particularly impressive, as it covers many of the top companies focused on the domestic economy. It suggests the corporate sector is in good shape.

There is every possibility that the economy will continue to grow steadily and markets will continue to perform well, despite their already impressive performance over the last 18 months. If so, then this rate hike could signal not just a turning point, but the start of a new upward cycle in rates, effectively resembling what we have seen in the US in recent years, where rates have risen gradually and predictably.

Although that is the possibility it is premature to say it is certain. For now, this is a one-off hike and the Bank will need to wait and see how the economy behaves. The Bank's immediate future actions need to be data dependent, with no need to rush.

Caution will dictate further action

Although the world economy is growing strongly and provisional indicators suggest the UK economy grew healthily in October – thus starting the fourth quarter in good shape – there are enough uncertainties at home to make the Bank of England tread carefully. These include the sensitivity of the economy to higher rates, the rising level of household indebtedness, the squeeze on disposable incomes, uncertainties associated with Brexit that may weigh on investment plans and the possibility of further political uncertainty, including the outside chance of a general election during the next two years.

The Bank voted 7-2 to hike interest rates from 0.25% to 0.5%, thereby reversing the rate cut of August 2016 and marking the first increase in a decade. That vote broadly mirrors how the Bank's actions appear to have been received by economists, commentators and the market: namely, widely supported, but some concern that this may have been the wrong time to tighten.

The hike, when it came, was not a surprise, as it had been heavily signalled by the Bank.

On the day, the Bank’s message was that higher rates were necessary to meet their inflation target and the market’s expectation of two more quarter point rate increases by 2020 made sense.

Positive and negative interpretations

The messaging allowed the hike to be interpreted in many different ways. On the positive, it reflected that the economy had performed better than the Bank expected at the time of the last Inflation Report in August, and that there was little spare capacity as unemployment had fallen to its lowest in over four decades.

On the negative, the Bank felt that even though inflation was about to peak it was likely to be above its 2% target for some time. Also, they felt the economy's potential growth was now sufficiently low to mean there was little spare capacity. The Bank now sees potential growth around 1.5%, a rate it has been steadily revising down since the 2008 financial crisis and before, when it felt potential growth was around 2.3%. This means it now believes the rate at which the economy can grow before it triggers inflation is less than before.

The implication is that if the economy grows above its potential 1.5% for any length of time the Bank expects this will trigger higher inflation and rates would need to tighten much more. Of course, you are entitled to ask, has not the economy grown at or above this rate over the last year and yet the Bank has told us that domestic inflation pressures are subdued? The answer is yes. Thus the inflation impact from sterling's devaluation is temporary.

The trouble is the ability of the Bank, and indeed for that matter, other central banks to predict the future path of inflation is not what it was. The Bank's forward guidance on inflation has been disastrously wrong in recent years. Even this year, when inflation has been rising the Bank was not pessimistic enough, thinking it would peak earlier and lower. Meanwhile, when it comes to the relationship between wages and unemployment, so key to inflation predictions, this is now very different to the past – not just in the UK but across western economies. Unemployment has continued to fall in recent years without generating the wage growth the Bank has previously expected.

In 2015 an assessment of the Bank’s forecasting record (by the Bank's Evaluation Office) showed that, of all the key variables that they forecast their “inflation forecasts have tended to be the least accurate at the two year ahead horizon.” Moreover, the same report showed, “these results could indicate that the Monetary Policy Committee did not build enough persistence from known shocks into its longer-horizon forecasts.”

Reasons to be cheerful, but also mindful of potential shocks

The signal to investors and savers is that it would be premature to conclude either that the Bank was right in hiking or that they have a well thought out plan about what to do next. Perhaps though, we should take note of what the Bank’s agents, who are based across the UK, are saying about wages.

A year ago these agents correctly predicted that they did not expect wage growth to rise this year. Now they expect upward pressure on wages in the year ahead – and I would agree with this. If so, then it would be good for disposable incomes and domestic growth, particularly as inflation is likely to decelerate.

The Bank was keen to highlight the importance of Brexit to their future thinking. The implication being that there are very different scenarios for the economy – and thus for rates – and this makes sense. That being said, they were far too pessimistic about the economy in the wake of the Referendum.

In coming months, the outlook for UK assets will be heavily influenced by both how Brexit talks fare in the run-up to December and also by the late November Budget. While we can envisage these events being market friendly, the reality is that there could also be shocks, hence the uncertainty. Notwithstanding this, the current macro-economic environment should allow UK assets to share in the current positive global investment climate driving equities. Bonds, too, could have a period of near-term calm, as the domestic interest rate picture is unlikely to alter much in the remainder of this year. It is by next spring that we should have greater insight into whether last Thursday was a one-off or the start of a slow upward trend in rates.

Please remember that when investing your capital is at risk.

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