ETF Securities Research Blog

If Bank of England doesn’t hike rates in 2017, then when?

One year on from the last rate cut, the Bank of England has kept rates on hold, with the MPC voting 6-2 in favour of the decision (roughly the same as last month). Although policy remains unchanged, GBP should remain supported by what is expected to be a tighter policy path in 20-17/2018. Indeed, Governor Carney indicated that policy may need to be tightened at a faster rate than the market is currently pricing.

While a decidedly cautious tone was struck by Governor Carney at the Bank of England press conference, tighter policy is coming: if UK economic growth continues at the rate the BOE has forecast, the market is underpricing the amount of policy tightening that is necessary.

The UK economy remains relatively resilient after the EU Referendum, with the unemployment rate at pre-crisis levels and evidence that both the manufacturing and services sector are growing in a robust manner. The reason for the additional Bank of England stimulus (a rate cut and additional asset purchases) a year ago was necessarily forward looking: ‘the weaker medium-term outlook for activity…[will lead to] an eventual rise in unemployment. The central bank seems to have become less proactive since then, highlighting that the UK is currently ‘in the teeth’ of the squeeze for households and both consumption growth and business investment will improve further in coming months.

Meanwhile, inflation remains elevated in the UK and well above the BOE’s target. The longer this continues, the greater the chance of expectations becoming unanchored, especially if energy prices rise again. While inflation hasn’t surprised to the upside in recent months, market implied inflationary expectations remain elevated (well above a year ago), and above other major economies.

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Current BOE Policy remains extremely accommodative. There may be uncertainties around the Brexit negotiations, but emergency interest rate settings do not seem appropriate. Indeed, Governor Carney notes that there are limits to what monetary policy can do relating to the Brexit situation. We expect that negotiations surrounding Brexit will remain in flux and that given there is unlikely to be significant progress made, the worst case scenario has already been digested by the market and GBP. In turn, the BOE is likely to unwind their Brexit induced rate cut from last year in H2 2017.

The key sentence in the BOE’s Monetary Policy Summary report is ‘The combination of high rates of profitability, especially in the export sector, the low cost of capital and limited spare capacity supports investment by UK firms over the forecast period, offsetting the effect of continued uncertainties around Brexit’. Surely if the economic uncertainty surrounding Brexit is offset, then the 2016 rate cut and additional stimulus should be unwound…if not in 2017, then when?

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