23 January 2018
The Bank of England continues to let the dust settle on last November’s interest rate hike – the first delivered in more than a decade. Certainly there have been few signs that this tentative start to policy normalisation has generated any material shock to the economy, although monetary policy does typically operate with longer lags. The Bank will take some satisfaction that the slow and steady signals it has been conveying around future tightening are being faithfully mirrored in current market pricing for Bank rate. It would not have wanted to allow markets to price in a more rapid normalisation at this stage, given the complicated policy outlook at present.
This outlook is not getting much easier for the Bank. On the growth front; performance has been mixed, with an acceleration in the global economy providing some support, but domestic demand still challenging. The effect of the global backdrop can be seen in improving industrial and manufacturing production, and rising sentiment in these sectors. On the home front; weak retail sales at the close of the year provided a timely reminder that the consumer environment remains subdued Overall, there is little to suggest that growth is evolving radically differently from the Bank’s forecasts. The same can be said of inflation. The Bank will be pleased that we have seemingly passed the peak in CPI inflation, with the headline measure edging lower to 3% year-on-year in December, from 3.1%. However, this trajectory is clearly in line with the Bank’s current estimates, suggesting little change to the trade-off it is facing around growth and inflation. This has been made more challenging on account of a tight labour market (see Chart 4). While there are signs that employment growth has slowed, there are few signs of slack emerging, helping to explain why the Bank felt the need to start tightening. Finally, Brexit continues to rumble on in the background. The minutes from the Bank’s December meeting flagged the progress late last year on exit issues, interpreting this as reducing the chances of a disruptive fall back to WTO rules. However, there is still a good deal of work to do before a transition arrangement can be agreed and more details emerge on the nature of the UK’s future trading relationship with the Single Market.
All this suggests that the Bank is unlikely to shift from its cautious guidance on policy any time soon. Recent comments from MPC members have broadly endorsed this message, although there seem to be some differences in view around what this might mean. Tenreyro sounded perhaps a little more dovish, arguing that there was ample time to see the effect of the November hike, and only a couple more moves would be needed in the next three years. Saunders, while cagey on policy, was more upbeat around the growth and inflation outlook, which would suggest that he views a quicker tightening as appropriate. We continue to expect one hike this year, and two in 2019, a slightly more aggressive view than that priced into markets (see Chart 5). This is contingent on gradual rises in domestic inflationary pressures (alongside a fading impact from sterling depreciation), slow but steady growth around the UK’s diminished potential and agreement on a transition deal for when the Article 50 deadline is due to expire in early 2019.