Posts tagged ‘Bank of England’
Counterfactual writing has been popular for many years. What if the Nazis had won the war in Europe? What if there had been no Reformation? Extending the genre to finance one might ask, what if the bond market had closed to Italy in 2011? (More of a niche market there, perhaps, but an interesting question nonetheless . . . )
Investment decision making by contrast concerns the future, of course, whose range of outcomes is practically limitless. Where the FTSE 100 index will close the year is a matter of opinion. A successful investor could be defined as someone who gets those sorts of things right more often than she gets them wrong. The only certainty she has, however, is that the future could hold almost anything.
And so to inflation, the UK, and what happens next.
The data out last week showing another uptick in the rate of price increases in Britain will have come as no surprise to readers of this blog. CPI is catching up with PPI output prices which have continued to catch up with PPI input prices, which have continued to come in at around 20% higher than the same time twelve months previously. Notably, “RPIX” – the rate of retail price inflation excluding the impact of mortgage interest payments and the rate once targeted by the Bank of England – came in at +3.5% year-on-year (to February). A full point above the old target, that would once have provoked a letter from the Governor to the Chancellor. CPI has only just got up to +2.3%, however, so under the new regime there is officially nothing to worry about.
Bearing in mind the enormous range of possibilities encompassed by the future we ought to be surprised at the strength of the consensus about what happens next. The Bank, the City, the leading independent forecasters: all are agreed that rising inflation will eat into wage packets, dampen growth, soften the labour market a little then fall away again. This time we all know how the story will end.
Taking this as read, then, let us try to be counterfactual, if only for entertainment’s sake.
On February data, real wage growth either flatlined (using CPI) or fell by 1% (using headline RPI). Let us follow the consensus in assuming that inflation grows by another point or so into the end of this year. That would push real wage growth down to between -1% and -2%.
Now: what if the effect of this was not only, or primarily, to impact growth? What if the expectation that wage growth will muddle along at a steady +2% is wrong? What if earnings actually start to rise to compensate for higher prices?
Like any good counterfactual tale our story needs to have its roots in genuine history to come across as believable to its readers.
In this case we might look at the distance travelled by the UK economy since the unemployment rate peaked in November 2011 at 8.5%. At that time average earnings growth was coming in at +1.7-1.8%, just a little lower than its present rate, though at the time this was a noteworthy trough and a level not seen since 1967. Wage growth subsequently fell further, hitting lows of +0.7-0.8% during the 2013-14 period. During those two years, however, employment growth had taken off in earnest with joblessness falling from 7.8% to 5.7%. Average earnings growth subsequently rose too, hitting +2.8% by mid-2015.
That British pay packets began to grow as spare workers became that bit harder to get hold of might well have been a complete coincidence. Indeed if we are to believe that earnings growth will not continue to accelerate today, as unemployment is down even further at 4.7%, equalling its post-1975 low, then that must be taken as read. The consensus, after all, is convinced of it.
Let us persist with our radical, counterfactual account, however. Suppose that labour market strength might genuinely correlate with wage growth. Where might that take us?
Prior to the Great Recession the average rate of earnings growth in the UK was +4%. Using a five-year lag from earlier peaks in unemployment wage growth reached +4.9% (February 1998) and +9.3% (May 1989). The economic, market and demographic environments were very different in their own ways at each of those different times, so the absolute numbers are not perhaps that illustrative. What they have in common is that they occurred during uptrends in wage growth established in the wake of falling unemployment.
For our fictional account of the British economy, then, let us assume that 2017 were to end with average earnings growing at 3-4%. With CPI and RPI inflation settling in the same range this would not represent boom times for wage packets in real terms. But it would not mean a growth-threatening contraction either. Expectations for increased labour market slack would surely go out of the window. Inflation projections would rise. Interest rate expectations would change. We might be entering 2018 worried not so much about contraction as about an overheating economy and a monetary policy that looked to have long since fallen behind the curve.
This is hardly a gripping, mass-market narrative. But it is the kind of thing that investors might want to weigh up in their thinking from time to time.
At least it would be if it were not the most absurd counterfactual, of course. Luckily the consensus is universally settled. We all know what is going to happen. In Britain’s immediate future, there is no alternative ending.
Let’s start with the facts.
- Yesterday saw the release of the Bank of England’s latest quarterly Inflation Report.
- For the second time, its growth forecast for 2017 was revised up. This now stands at 2% as against the 0.8% forecast in the wake of the EU referendum result, which the Bank officially and Mark Carney personally expected to usher in immediate economic disaster.
- Projected unemployment now stands at 5.0%, up from a 2017 forecast of 5.5% last August.
- Despite this the CPI forecast for this year has been trimmed back: to 2.7% down from 2.8% back in November.
- The “equilibrium unemployment rate” [a.k.a. the “natural unemployment rate”, a.k.a. the “non accelerating inflation rate of unemployment” (NAIRU)] has been revised down from 5% to “around” 4.5%.
- Despite its lower CPI forecast the Bank’s sub-trend growth forecast for the years following this one (+1.6% for both 2018 and 2019) is predicated on squeezed real wages under pressure from higher inflation.
Governor Carney took considerable pains to wipe the egg off his face by way of his opening remarks to the press conference yesterday. He admitted, obliquely, that consumer behaviour has not remotely suffered in the way which the Bank assumed it would last summer. But this was dismissed as the least important reason for the higher growth outlook, behind the Autumn Statement, improvements in economic confidence abroad and supportive financial conditions. Be that as it may, Mr Carney’s insouciant defence of his institution’s forecasting record does speak of a certain strength of character and for that at least he may perhaps be applauded.
The fact remains, however, that monetary conditions are still set firmly in emergency mode at a time when inflation is projected to exceed the notional target, the economy is close to full employment and growth is nudging trend. From its rhetoric, however, the Bank is wedded to accommodating unspecified and unquantifiable risks surrounding Brexit and seems intent on keeping policy unchanged for the foreseeable future.
This already looked curious last summer. Today it seems downright insane.
Now to the conspiracy.
Britain is no stranger to having her financial affairs managed on the basis of seeming insanity. Back in 1999 Gordon Brown infamously sold a large amount of the country’s gold reserves in an auction process which he announced publicly in advance. This secured him a bargain basement price for the sale. Gold subsequently multiplied in value and the period was dubbed the “Brown bottom” as a result.
The official explanation for the sale was that it would rebalance the country’s foreign exchange reserves away from a volatile commodity and into thrusting new assets such as euros. Gossip emerged later, however, that at least one major bank, likely JP Morgan, had been shorting gold to fund asset purchases in some size – a classic “carry trade” – and was threatened with serious difficulties should the price rise. Brown’s actions were therefore explicable as being for the greater good of the financial sector: there was method in the madness.
A similar case could be made today. The Brexit vote set sterling on a downward trend which persisted into the autumn. Last year’s foreign asset returns, in sterling terms, were astronomically higher than long run expected rates. And with interest rates near zero the pound is very cheap to borrow. (Remember too that it is one of the world’s reserve currencies and extremely liquid.)
Last year, then, the sterling carry trade was one of the deals of the century. As with the gold carry trade in the 90s, however, if the price of the borrowed asset goes up it doesn’t look very good for the borrowers. A rise in the value of the pound due to changing expectations for interest rates could well pose a risk to one or more banks assessable by a Bank of England Governor as systemic.
Surely it would be absurd to think that the MPC was secretly conspiring to hold down the value of sterling? Well – probably. But its official position appears no less absurd. It is also worth noting that the one key reaction to yesterday’s release and Mark Carney’s comments was a fall in the value of the pound. (Sterling had gone up as high as $1.27 in the morning, then crashed down towards $1.25 again over the course of the day.) The Bank’s forecast for the exchange rate is of near-complete stability at the current level into 2019 – or should that read, “the Bank’s target”?
It is an intriguing possibility. But this blog cannot go in for tin foil hats. So let us conclude simply by repeating the observation that the Bank’s current stance is extraordinary, and, apparently, inexplicable.
Earlier this month the Bank of England took a dramatic monetary leap, largely in the dark. Since then, however, some actual economic data has emerged for July – which is of course to say, post-referendum. We do not yet have a completely clear picture of the Brexit result’s impact on the country. And we still remain part of the EU for now (and are included as such, hilariously, in an alternative analysis of the Rio medals table). So whatever impact is shown in the July figures – if any – will reflect nothing more than confidence.
What signals there are, have been mixed.
One area of concern has been the property market. So far this one is still a bit of a grey area though we do have some numbers. HBOS published their July house price index on the 5th and it showed a fall of 1% for the month – but this is a very volatile series and the smoothed year-on-year data was still running at +8.4%. (The Land Registry series, which is the most comprehensive and statistically robust overview of the residential market, will not be out until next month.)
We also had the RICS agent survey out on the 11th. Last month, a net +5% expected rising prices, down from +15% in June. This is a very volatile series which has ranged between -92% and +59% over the last ten years, with an average of zero. Furthermore the number, while reduced, remains positive so this is not perhaps as concerning as all that.
We will know more at the end of August when mortgage approvals data appear. Until then the mist over British housing has not quite cleared, but what we can discern ought not to panic us so far.
On the commercial property front, as widely expected, there was more evidence of gloom. The IPD dataset for privately-held assets posted a fall of 2.4% on the month with no new purchases made. Whether driven by sentiment or not, this may turn out to be an area where the bearish expectations for a Brexit result are borne out to one extent or another.
Turning to consumer activity, this might have been expected to drop off a bit if GfK’s confidence numbers were to be weighted with significance. But there is no evidence of this.
Firstly, new car registrations for July came in ever so slightly higher than in July last year (178.5k versus 178.4k). So there were no signs of decline on the Major Purchases front here.
Then we had retail sales data out yesterday. This was so strong it surprised everybody: +1.4% on the month, and +5.9% year-on-year, the highest annual rate since September 2015.
On the basis of consumer activity therefore one might be tempted to disregard those confidence numbers entirely, but it is early days.
On the industrial activity front we have almost nothing to report. (Production and growth data released this month pertained only to June.) On the 3rd we saw undeniably weak PMI data, pointing to a contraction: the composite indicator came out at 47.5, down from 52.5 in June, 50 being the neutral level. We will have to wait and see how this translates into the official statistics.
Arguably the most interesting data concerned price behaviour. CPI and RPI prints (out on Tuesday) showed a slight increase in headline inflation, up to +0.6% and +1.9% year-on-year respectively from +0.5% and +1.6% in June. But it was the industrial PPI data which caught the eye.
Sterling has of course weakened since the referendum and this was projected to lead to input price rises of 1.0% on the month and 2.0% on the year. In fact the outturns were +3.3% and +4.3%, materially higher than the highest individual forecast in each case.
Look below the surface and there could be more of this to come. After all, the trade weighted sterling index for July averaged 7.4% below its level for June and 14.9% below the average for July 2015. Offsetting this was the soft oil price last month, down 6.5% from June on average and 18.2% below the average for July 2015 as measured by the Brent Crude future.
Now the average price for oil in August-September last year was $48.46 per barrel, as against over $50 today. This is significant because it means the impact of the pound’s weakness on input prices is not likely to be contained by the disinflationary influence of cheap energy over coming months. And unless sterling stages a big rally the inflationary impact from the currency will persist for up to a year. That inflation – which means higher costs for industry – will need to be passed on to consumers or it will squeeze margins. The other side of the coin is more competitive exports, of course, but this aspect is bad news for the economy.
Finally, the employment data on Wednesday drew some attention from people who seem to have expected instant post-referendum trauma from this textbook lagging indicator. (In the event the ILO unemployment rate was unchanged at 4.9% with the claimant count down by a few thousand.) This says more about the level of bearishness in some quarters than anything else. Similarly, today’s numbers on government borrowing might well have been a little worse than hoped for but in the words of the Office for Budget Responsibility: “Any underlying weakness in the latest data is mainly likely to reflect pre-referendum economic activity.”
Overall there is little reason to panic as Britain’s post-referendum economic landscape has begun to reveal itself. On the bear side, commercial property is an obvious one to watch, and imported inflation could start to cause headaches into the end of the year. Elsewhere there is but little sign of any stress in the residential property market. Indeed, the UK consumer has shown clear signs of increased activity.
We shall of course have to wait and see what happens next – not least in terms of the Brexit deal which is ultimately, at some point, secured. But if we look at the numbers which have come out over the last couple of weeks it does appear that the Bank of England has sacrificed its inflation target prematurely.
Perhaps it was inevitable that the Brexit vote would herald the end of more than one era.
Yesterday the Bank of England took a series of eye-catching expansionary measures in response to the vote, as expected. One of the consequences of this was the explicit abandonment of its two-year inflation target. CPI inflation is projected to exceed its 2% target by the end of next year and stabilize at 2.4% from 2018 into 2019. For the first time since the “Ken and Eddie show” began in 1993 the Old Lady is wandering quite happily away from her inflation mandate. The justification for this is labour market weakness and slower growth supposedly arising from Brexit and surrounding uncertainty, which is perfectly understandable. In previous Inflation Reports, however, such justification has always underpinned monetary shifts which were to result in the path of UK inflation reaching 2% in two years’ time – growth and employment objectives being officially “subject to that”.
Not any more.
In fact this month’s Inflation Report might as well have been called the Brexit Guesstimate Report, as that was the gist of nearly all of it. On what the Bank itself admits is incomplete evidence, much of which conflicts, it has taken the most dramatic series of monetary steps since the financial crisis. They are:
- Cutting the base rate to 0.25%
- Increasing QE by £60bn (gilts) and £10bn (corporate bonds)
- Introducing an emergency bank lending programme called the Term Funding Scheme (TFS), supported by a change to the regulatory capital framework
The base rate cut was as almost universally expected, and clear signals have been given that a further cut to “close to, but a little above, zero” is on the cards for later in the year. This is thought likely to be at the November meeting so that it coincides with another so-called Inflation Report (the MPC’s preference this time). Who knows?
The British “QE3” was not quite so widely expected, with just over half of the 44 economic estimates compiled by Bloomberg pointing to no change. With government borrowing running at well over QE target levels the conceptual efficacy of a “helicopter drop” has always been suspect and the practical impact of its own programme on the US economy has been estimated by the Fed to be almost zero. The announcement has, however, already pulled gilt yields even lower, which will give Chancellor Hammond, on paper, much improved budgetary arithmetic for his Autumn Statement in due course. (It is notable that the very first QE target was for £75bn of purchases so Mr Carney thinks that about as much bond market intervention is warranted amid today’s uncertainty as his predecessor did in the teeth of the most vicious global recession since the last world war.)
The TFS “element” is especially significant. We know that low interest rates have hurt bank profits – along with much else (have YOU been mis-sold PPI?). So the TFS encourages the banks and other lenders to take advantage of this week’s rate cut by offering them access to £100bn worth of borrowing direct from central bank reserves at base rate. The condition is that they use it to increase their net lending. To facilitate this, the rules have been changed so that central bank deposits do not have to be covered by capital reserves. On the Bank of England’s maths the direct access to base rate financing will represent an interest rate cut of 75bp to the extent this facility is used by the banking system, not the headline 25bp. Again, by way of comparison: the Special Liquidity Scheme operated by the Bank as the credit crunch reached its most crushing in 2008 peaked at the exchange of £185bn worth of government paper for illiquid assets. And of course the TFS is expandable from here.
To reiterate: the evidence we have to support all this drama is incomplete and, in part, conflicting. As the Bank itself notes, the Markit UK PMI output measure dipped below 50 in July (neutral activity) but the lower-profile Lloyds Business Barometer recovered to its pre-referendum level. In both cases we have only a single month to go on. Then there is the property market. While there is clear evidence of short term demand loss in the commercial property market the accompanying weakness in residential property, a supposed outcome which is cited as a key factor in the MPC’s judgement, is predicated on labour market developments which remain unclear. The Inflation Report points out, correctly, that available survey data (including from the Bank’s own agents) has indicated that those businesses who do expect there to be a referendum impact on their hiring decisions – very far from all of them – expect to respond by reducing recruitment, not by laying staff off. This sits oddly with the projection for a rise in unemployment from 4.9% as of May to 5.5% by the end of next year.
It is, of course, possible that events will turn out as the MPC seems to feel in its collective gut might be the case. But it is largely on the basis of such a gut feeling that it has chosen to enact a series of monetary measures comparable in their scale and ambition with the emergency steps taken during the worst of the credit crunch and Great Recession. Should this feeling be characterized as expert intuition? Or panic?
Even if it is the former, throwing out the inflation target is a huge move, and one which has not yet attracted the attention it merits.
We are now more than half way through 2016. As the year dawned this blog identified monetary policy and the oil price as two of the key things to watch. This week it was the turn of the Bank of England to set tongues wagging on the monetary front; in the meantime the oil price, which has done some central banks such a favour in recent years, has stabilized in the $45-50 range following its strongest quarterly rise for seven years.
The Bank had been expected to cut policy yesterday (from 0.5% to 0.25%). A Brexit loosening to buoy confidence had been the thinking behind this consensus. The MPC, however, held steady. Admittedly the consensus was not especially strong: of the 54 estimates collated by Bloomberg 25 had been for a 25bp cut, 6 for larger cuts and the remaining 23 (who won the bet) for no change. Nor was the defeat especially hard. The MPC announced that “most members of the Committee expect monetary policy to be loosened in August”, further noting that the “precise size and nature of any stimulatory measures will be determined during the August forecast and Inflation Report round.”
If, in the words of one senior figure on Threadneedle Street, the British economy needs a post-referendum “sledgehammer” (not an obvious choice of metaphor for a stimulus but one catches his drift), then why delay? If the Bank is to bolster confidence why didn’t it just get on with it? What sort of doctor decides that his patient, suffering some obvious ailment, could really do with a shot in the arm – but then decide to wait another month before administering it?
On the other hand, as that senior figure – MPC member Andy Haldane, the Bank’s chief economist – further put it, while there is some evidence of weakness in hiring and investment: “There is no sense of slash and burn. But there is a strong sense of trim and singe.”
In any event the point is that we do not yet know what the impact of the Brexit vote has been. There is anecdotal evidence from the property market, for instance. But it won’t be until at least early August that we have much actual data to look at.
There is an irregular exception which we ought to deal with quickly. GfK, who produce the UK consumer confidence series, undertook a one-off bonus survey in the aftermath of the referendum. (Their regular end-June number was based on surveys conducted during the first two weeks of the month.) Published last Friday this showed a fall in the index from -1 to -9, the biggest monthly decline since December 1994. On the other hand, the index has averaged precisely -9 over the last 30 years, peaked at only +7 in mid-2015 and went as low as -39 at the nadir of the Great Recession.
One thing we do know for a fact, however, is that the pound is 7% weaker, trade weighted, than it was when the last Inflation Report was published in May. It is down 11.5% in 2016 to date and has fallen 13% since its peak just under one year ago. Currency weakness is itself a form of monetary loosening which translates into imported inflation, higher exports and (not allowing for Brexit fears) greater inward investment. Is a cut of 25bp on the base rate really required as well? Particularly as the urgency of such a move is clearly not great enough to obviate the delay associated with data releases as well as the elegance of wanting to time MPC action to coincide with the publication of the Bank’s own detailed economic and monetary analysis?
And so back to oil. This is now back at exactly the level it settled at for a few months from last August. Very soon, then, the deflationary effect it has over the previous year will reduce to about zero. In February the Bank put the contribution of cheap oil to annual CPI at -0.4% through direct effects alone. That is quite a lot of disinflation to be giving up. The next RPI and CPI prints come out on Monday, with figures for July only arriving until after the next MPC meeting. So they may not be sufficient to challenge what will doubtless be a 100% consensus, backed by the MPC’s own words, for a 25bp cut next time. But the direction of travel is clear.
There is also the labour market to consider: 186,000 jobs were created during the first quarter of this year, and the ILO unemployment rate at 5% is only 0.3% off its 2004 low. Brexit risks may argue for a rate cut (though again, on that basis: why wait?) But the pound, the oil price and the labour market argue at least for staying put in August too.
The complication for investors here is that markets were already mildly disappointed with the Bank’s failure to cut yesterday. Put it off again, or postpone it indefinitely, and their disappointment may lose that mildness.
There is another possibility to consider: that Brexit fears might recede in coming months. What then for prices? And for monetary policy? And for bond markets, with the UK base rate not priced to rise above its current level until the end of 2020?
As so often our central bank finds itself in a bit of a spot. Nervousness pushes its hand one way; known fundamentals to date, at least, another. If the data which comes out between now and the next MPC meeting is unhelpful to the consensus the Bank can either act inappropriately or spook the market. If the data is poor, and so helps the post-referendum blues argument, then that is bad news for the economy.
Whatever the longer-term consequences of Brexit for the UK the shorter term prognosis for assets of certain types does not look rosy.
Central bank activity has been a linchpin feature of market activity in recent years. Rather than following rate trajectories and getting on with life, markets have been paying such attention to every last detail of bankers’ announcements and emergency programmes around the world that there have been some curious butterfly effects. In 2013 for instance the Fed announced that one day, quantitative easing would come to a halt. Now this programme had exhibited next to no economic effect on the US itself. But it weakened the currency of Brazil to such an extent that rates went up to defend against import price inflation, thereby contributing to that country’s recession and associated woes.
So what have central banks been up to lately, and what might come of it?
In the US the Fed has attracted criticism for its confusing guidance ever since it bottled tightening policy last autumn. The most recent statement from Chair Yellen said she was “cautiously optimistic” on prospects for the US economy, and she has said on several occasions that she would rather point people towards indicators which the Fed follows than give specific commitments to policy decisions in advance, which is understandable. But it has created uncertainty: some observers find signs in the data that the Fed is falling behind the curve, while others see no case for any more tightening at all this year. Markets are pricing in no move over the summer – which conflicts with Fed briefings as recent as 12 days ago – but expect the target rate to have risen to 0.75% by the end of 2016. Bloomberg summarized the situation well in a piece headlined: “Yellen Data Dependence Leaves Investors Dazed And Confused“.
For investors, this means continued uncertainty over the imminent path of US interest rates and that is not a comfortable situation for markets to find themselves in. Today’s sell off in equity on both sides of the Atlantic is, in part, a reflection of this. As to what will actually happen it is plainly anyone’s guess though if oil remains at the $50 level the deflationary contribution from energy will fade in August, core inflation remains above 2% and last week there was a positive data surprise in the form of a 4.7% unemployment rate (down from 5% and a new post-Great Recession low). Fundamentals aside, however, the Yellen era has been characterized thus far by uncertainty and that remains the key watch point from the Fed at present.
Over at the ECB talk on monetary measures has quietened down, though a noteworthy kilometrestone was reached this week when the bank began its latest phase of QE through buying corporate debt. Mr Draghi has instead been opining on supply side reform and keeping a studied silence on some issues which might possibly be of broader interest, such as the ability of Greece to finance itself next month.
That particular elephant in the room, and perhaps – who knows? – a Brexit vote here in a couple of weeks will give investors rather more to chew on than the ECB’s plans for monetary policy over the next few months. Having said that, eurozone unemployment has stayed stuck above 10% despite what passes there for a robust rate of growth. (Mr Draghi certainly does have a point about structural reform.) There is no realistic prospect of monetary tightening for a long time: markets suggest 2020. The ECB watch point for markets will be rhetoric and planning over emergency measures. However effective they may or may not be in practice their announcement always carries the power to disappoint and while a second-order issue relative to European politics at the moment this remains a source of risk.
Over at the Bank of Japan the story is similar. The yen has strengthened by 11% this year which is a disaster for Japan’s economy. Abenomics, too, have been faltering for some time. Deflation is back. The central bank is torn over the issue of negative interest rates adopted earlier this year and whose effects, if there are to be any, have yet to be felt. At a public meeting this week Deputy Governor Nakaso signalled the BoJ would do more if needed – but this was possibly nothing more than an effort to talk the currency down.
The BoJ’s next meeting is next week. It has not attracted half so much of the market’s attention as the Fed or the ECB but as in Europe the watch point is the reaction to policy announcements. If the BoJ adopts more emergency measures unexpectedly that could give Tokyo a nice boost, especially if it led to a weaker yen. The interest here though is more domestic than global for now.
Over at Threadneedle Street there has been a period of calm – at least on the monetary front. (Mr Carney’s regular warnings about the dire consequences of a Brexit have been a feature of life at the Bank of England since the early spring.) Rates wise expectations are as low as they were during the panic in February and the futures market is not pricing for an increase in the base rate until the second half of 2018.
In terms of things to watch the Old Lady is at the more interesting end of the spectrum. Carney has decried negative rates as ushering in a “zero sum game” via currency wars but that was before the hideous spectre of Brexit loomed. The possibility of negative rates has been mooted by one of his MPC confreres and if the Bank is serious about its rhetoric a Brexit vote could see a major surprise in that direction. That would potentially be great news for gilts but probably not much else.
On the other hand the May Inflation Report, as usual, forecast that under present conditions CPI would bosh back up to 2% in time to meet the Bank’s commitment to that target on a two year horizon. We know about the fading of energy-driven deflation. We know that the UK economy is at or close to full employment. The industrial production number for May was the strongest in nearly four years and core CPI inflation, which bottomed at 0.8% over a year ago, has yet to fall below 1.2% in 2016. So we could find ourselves with something of an earlier hike than is currently priced in, and that again might surprise markets depending on the circumstances.
Despite the dominance of politics there is thus much to follow from the central bankers, and most of it would seem to present more of a threat to risk markets than an opportunity.
A speech to the G20 summit in Shanghai from the Governor of the Bank of England has drawn some media interest today. Mark Carney’s words of caution to his fellow central bankers on the subject of negative interest rates centred on the “zero sum game” of seeking export-led recovery. He noted, quite rightly, that “beggar-thy-neighbour” policies at the country level would do nothing to address the sluggishness of global demand. And only on Tuesday he told the Treasury Select Committee that Britain’s policy rate would not go negative.
He did, however, say that it might be cut.
Sterling hit a new trade-weighted low on Wednesday and has now fallen by more than 10% from its August peak to a level last seen two years ago. Now the downward trend started back in November and has also received a helping hand from David Cameron’s successful reform of the European Union last Friday. But Governor Carney’s words, and those of his colleagues on the MPC this week, do undermine the credibility of his Chinese lecture at least a little.
This is especially the case since the pound’s impact on inflation has long been singled out in the Bank’s quarterly reports on the subject. A bout of moderate currency weakness could give a nice boost to CPI, if only on a forecast basis, bringing it closer to the target rate of 2% per annum without the MPC having to resort to any further loosening of policy over the coming months. And the side effect of a positive impact on British exports is just something the Bank would, regrettably of course, have to live with.
Look at the last Inflation Report and the underlying data, however, and even sterling is a side-show. As so often over the past 18 months the big news is oil.
This blog wrote about the impact of energy prices on the Bank’s assumptions for inflation back in November. Since then the effect has grown. Oil price assumptions for this year and next are down by 34% and 29% respectively; forecasts for gas prices down by 24% and 21%. On the MPC’s arithmetic this is in the process of translating into added deflationary pressure in 2016 of 0.4% p.a. by way of petrol prices and gas bills alone, with additional effects via the pass through of lower production costs (this being more difficult to time as well as to quantify).
It is, then, unsurprising that it has been oil, not sterling, which has exerted the more powerful pressure on interest rate expectations. These were already very benign, with UK rates only expected to rise late this year or some time into next. Look at futures markets today, however, and they are not pricing in any chance of policy tightening until the second half of 2018, with the base rate remaining under 1% until at least the end of the following year. As with the pound this change has been quite rapid. The 3-month LIBOR future for December 2019, which now prices at 1.02%, was priced at 2% on New Year’s Eve.
While the press looks to the pound, therefore, the rates market has been looking at the oil price.
And yet even the February Inflation Report is rightly cautious on this subject. It notes that the drag from lower energy prices will unwind over time, and that its CPI forecast on a three year view is broadly unchanged. Elsewhere it further notes that the labour market has strengthened more rapidly than expected back in the autumn: in fact it now forecasts UK unemployment of 4.8% both this year and next, revised down from 5.2% and 5.0% respectively. This is nothing less than a prediction of full employment, if the history of the last forty years is any guide. And at the same time the ratio of vacancies to the total labour force has risen again. This measure averaged 1.5x over the period 2010-12, when the UK labour market stagnated around an 8% level. Then it rose to 1.7x in 2013 and 2.0x in 2014, a time of rapid jobs growth which saw unemployment reduce to 5.7%. For 2015 the ratio hit 2.3x and unemployment already stood as low as 5.1% come December.
Under normal circumstances this would ignite at least an amber warning of cost pressures by way of wage increases. At present, however, this pressure is contained by the current low level of headline CPI, as the Bank also notes. (What the Bank doesn’t note but is nonetheless equally material is that low inflation has a direct impact on wage settlements in the public sector – about one in every six jobs in Britain – together with pensions and other welfare payments.)
The UK is close to full employment, the deflationary impact of a strong pound has fallen away in short order and price pressures are being contained only by the continued weakness of a commodity whose average annual price change in either direction over the last ten calendar years has been 30%. Interest rate markets are expecting this happy circumstance to persist for at least the next two to three years. From some perspectives – that of the property market, for instance – it would be lovely if they were right. But the more prudent thing to do, surely, is to think about what might happen if they are not.
Let us leave the last word to the Bank of England:
“At its meeting ending on 3 February, the MPC judged it appropriate to leave the stance of monetary policy unchanged . . . All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.
This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on the economic circumstances.“