A change in tone
20 February 2018
The Bank of England’s February meeting provided an opportunity for the MPC to signal its take on the recent volatility in financial markets. In general, the message was a sanguine one, although Governor Carney did stress that the Bank would continue to monitor market developments closely. The main focus however, was the shift in tone from the Bank, with policy to be “tightened somewhat earlier and by a somewhat greater extent” than had been anticipated back in November. This more hawkish message is predicated on the view that slack in the UK economy has diminished, meaning that there is greater confidence on the MPC that domestic inflationary pressures will build over the forecast horizon. Indeed, the Bank’s forecasts, conditioned on market interest-rate pricing, continue to signal an overshoot in inflation on these timescales. This reinforced the message that a slightly quicker adjustment in policy is required. Following the meeting we heard from various MPC members, who broadly endorsed this more hawkish tilt. In particular, it was interesting to hear Gertjan Vlieghe, traditionally of a more dovish persuasion, reasserting the message that faster tightening was required. In the wake of these signals we now expect the Bank to hike rates twice this year (in May and November) and twice next, 25bps more than we had previously factored in and a little above the latest market pricing (see Chart 4).
This more pronounced hiking cycle will of course be data dependent. Signs of a weakening in the growth outlook, softness in the labour market, or weaker underlying inflation will all be triggers to move more slowly. There are naturally questions around how much tightening the economy can withstand at the current juncture. There has been a muted reaction in deposit and lending rates following the November rate hike; however, monetary policy does operate with a lag. The UK consumer has been resilient through the inflationary squeezes in real incomes, but the Q4 2017 GDP growth report signalled weak consumer-facing services activity. Meanwhile, retail sales started this year on a soft note. We will have to watch closely to see if consumers are finding it harder going. With UK growth traditionally dependent on the performance of service sectors, the ability of rising industrial production and external trade, alongside a global cyclical upturn, to offset any weakness here is uncertain. On the inflation front, the Bank is putting a large onus on its latest agent’s report, which suggests an acceleration in wage settlements this year. If this is not delivered then the Bank could become less confident in its inflation forecasts (see Chart 5).
A further disruption to the future path of UK interest rates could come from an upset in the Brexit negotiations. In particular, the Bank has based its forecasts on the assumption that Brexit is a smooth process. Signs that the negotiations are not progressing as expected would likely lead to a reassessment of the impact of Brexit on these forecasts. Most disruptive would be signs that the UK is headed towards a fall back to WTO rules with its largest trade partner. While our base case is that a transition deal is reached, helping avoid this cliff-edge scenario, we are wary that there may be increased uncertainty as the negotiations progress.