BoE still expects rate rises – just not yet
Azad Zangana, senior European economist at Schroders, comments on the latest Bank of England interest rate decision and Inflation Report
The Bank of England (BoE) announced on 4 February that it was leaving the main policy interest rate at the record low level of 0.50% – in other words, no change for the 83rd consecutive month – along with keeping its asset purchase facility held at £375bn.
Importantly, external monetary policy committee (MPC) member Ian McCafferty has decided not to vote for an immediate increase in the interest rate this time, having voted for an increase in the previous six meetings. He joins the rest of the committee in voting for no change. The shift in voting suggests the balance of risks has shifted to the downside on growth and inflation.
"The main challenge for the BoE is to communicate a more cautious stance but not to change the overall message of the economy progressing well."
Indeed, the MPC meeting minutes suggest the worsening international outlook has adversely impacted global commodity prices and international trade and has tightened global financial conditions. These factors are likely to be having a negative impact on UK growth. The Bank not only lowered its forecast for GDP growth in the near term but also for inflation as lower energy prices are expected to keep overall cost pressures near zero for longer.
The main challenge for the BoE is to communicate a more cautious stance to the public and markets compared with November’s Inflation Report, but not to change the overall message of the economy progressing well and that interest rates are likely to rise in the future. Markets currently place a greater probability on the BoE cutting interest rates this year, and are not pricing in a rate increase until the middle of 2018.
The Bank, which uses the market’s path of interest rates to condition its growth and inflation forecasts, suggests the market is not pricing in enough interest rate rises and that, should the BoE follow such a path, then inflation would overshoot the Bank’s 2% inflation target two and three years out. Indeed, in the Inflation Report press conference, governor Mark Carney was keen to signal that the MPC feels interest rates are more likely to rise than not in the future.
Details of the latest Inflation Report also show the BoE expects the labour market participation rate to stabilise at current levels and for average hours worked to fall – resuming its pre-crisis trend. These suggest there is less spare capacity in the economy than previously thought.
Indeed, the BoE expects excess spare capacity in the economy to be utilised by the end of this year, which should help wages to accelerate to support household demand. The Bank’s more hawkish assessment on spare capacity also suggests the Bank is gearing up for the first rate rise since June 2007. The main obstacle to this is the anaemic rate of inflation.
Our forecast for the first rate rise is predicated on inflation being above 1% (the BoE’s lower target) and the economy growing at a steady pace. Based on our latest inflation forecast, this suggests the first rate rise may happen either around the end of the year or the start of 2017. One major difference between the Schroders forecast and the BoE’s, however, is that we forecast GDP growth to slow in 2017 on the back of accelerated austerity and higher inflation.
The BoE, on the other hand, expects growth to accelerate in 2017, from a temporary dip this year. If the Bank is right, it should continue to raise interest rates at a steady pace through the whole of 2017. If growth slows as we expect, however, the Bank may have to pause its hiking cycle or even reverse it. At present, the risks are clearly skewed towards rate hikes being delayed – perhaps indefinitely.
Hope and hype
The ECB may have disappointed markets with its latest policy measures but, says Azad Zangana, senior European economist and strategist at Schroders, investors should have paid more attention to the improving macro data
So much hype and yet so much disappointment. European Central Bank (ECB) president Mario Draghi’s reputation for always over-delivering stimulus against market expectations is now over. After spending the last two months strongly suggesting a significant increase in monetary policy stimulus measures, Draghi has under-delivered.
Five policy changes were announced on 3 December:
* The deposit rate has been cut from -0.20% to -0.30% although the main refinancing rate and marginal lending rates have been left unchanged (0.05% and 0.30% respectively).
* Quantitative easing (QE) of €60bn (£43bn) per month is now to be extended until March 2017. It was previously due to end in September 2016.
"The difficulty for Draghi in his push for further stimulus is the outlook for the eurozone did not necessarily warrant it."
* The ECB will now reinvest the principle payments of maturing assets under QE, for as long as necessary.
* Regional and local government debt has been added to the list of eligible assets for QE.
* Main refinancing operations (MROs) and three-month long-term refinancing operations (LTROs) are to be used until at least the end of 2017.
Against the menu of policy changes announced, markets were expecting at least a 20 basis points cut in the deposit rate, along with at least €20bn added to the monthly QE purchases. Given the disappointment, the euro initially rose by about 2.2% against the US dollar, while European bourses fell sharply. Clearly Draghi needs to re-examine his communication strategy. Seeming to always better what the market was anticipating was bound to lead to unrealistic expectations eventually – and therefore to disappointment.
Compared with our own forecast, we were not expecting an increase in monthly purchases, but were expecting an extension – albeit only until the end of 2016. The further cut in the deposit rate was also not factored in to our forecast, but we do not expect it to have much of an impact on growth or inflation. The other measures are designed to reduce the risk of technical difficulties hampering the implementation and the withdrawal of QE.
The difficulty for Draghi in his push for further stimulus is the outlook for the eurozone did not necessarily warrant it. Recent activity indicators have continued to improve despite the weaker external environment and concerns about security. Low inflation has boosted the disposable income of households in real terms, while the resumption of credit flows is boosting domestic demand, aided by low interest rates.
Also, the euro had depreciated sharply from around 1.14 against the US dollar since October to as high as 1.08 in the wake of the ECB announcement. The ECB’s decision not to increase the amount of monthly purchases leaves some powder dry in case additional stimulus is needed next year. The Bank is clearly concerned about the capacity for purchases, given the limited supply of eligible assets and its own purchase limits – hence the inclusion of regional and local debt as eligible assets.
Overall, the additional stimulus announced on 3 December may have a marginally positive impact on the outlook for the monetary union. Investors caught out will have to learn to look more closely at data and not expect the ECB always to look to appease them. We now look forward to the US Federal Reserve’s policy decision. Assuming Janet Yellen follows through this time and raises interest rates as expected, we could see the euro resume its recent depreciating trend.