Will the next move in interest rates be up or down? - Capital Economics
UK Economics

Will the next move in interest rates be up or down?

UK Economics Focus
Written by Ruth Gregory
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We suspect that interest rates will neither go up nor down this year! But the markets may be caught out further ahead if, as we expect, a fiscal stimulus and easing in Brexit uncertainty results in interest rates rising above their current rate of 0.75% by the end of 2021.

  • We suspect that interest rates will neither go up nor down this year! But the markets may be caught out further ahead if, as we expect, a fiscal stimulus and easing in Brexit uncertainty results in interest rates rising above their current rate of 0.75% by the end of 2021.
  • Investors’ expectations for the future path of interest rates have changed dramatically since the start of 2019. A year ago, the markets were pricing in about two 25 basis point (bp) rate hikes from the current level of 0.75%, but they are now pricing in a 25bp cut by the spring and a 35% chance of a further 25bp cut by this time next year.
  • It is easy to see why. There is clear daylight between the current rate of GDP growth and our estimate of its potential rate and at 1.3%, CPI inflation is well below its 2% target. Other indicators, such as the activity PMIs, have fallen into the territory where rates have been cut before.
  • Little wonder, then, that two of the nine members of the MPC have voted for rates to be cut immediately to 0.50%. And the multitude of comments over the past few weeks have suggested that other MPC members are becoming more open to the idea of cutting rates, perhaps even as soon as the MPC’s next meeting on 30th January.
  • Of course, the primary reason why most MPC members did not vote to lower rates in December was because they wanted more time to judge whether the election has prompted a reduction in Brexit uncertainty and a turnaround in the data.
  • And so far at least, there have been some reassuring signs of an improving economic picture. The latest news on Brexit uncertainty has been encouraging. There have been signs of improvement in the activity surveys. And the tentative evidence of stabilisation, as well as the Phase One trade deal between the US and China, may also have alleviated the MPC’s concerns about a further weakening in global growth.
  • We wouldn’t argue with the financial markets that there is a decent chance of an interest rate cut on 30th January. Provided, though, that the surveys continue to show signs of improvement, our hunch is that the MPC will sit tight and leave rates on hold at 0.75%.
  • At the very least, a tightening of monetary policy still looks a long way off. Admittedly, the Bank of England has not fully factored in the coming fiscal stimulus worth 0.5% of GDP that we expect to be announced in the Budget on 11th March. And the rise in firms’ unit labour costs, from close to zero to around 3.5% over the last four years, could be passed onto consumers in the form of higher prices.
  • However, with Brexit uncertainty lingering, businesses may remain relatively cautious about raising their prices. Meanwhile, we suspect the MPC might conclude, like us, that the fiscal stimulus won’t provide an especially large boost to inflation. Indeed, the MPC may be wary about repeating the US Fed’s mistake of overestimating inflation after a fiscal stimulus and raising rates too far.
  • In light of all this, our best bet is that interest rates will stay on hold at 0.75% this year and at the start of 2021. But with the economy riding the wave of a fiscal stimulus and Brexit uncertainty waning, we think that rates will go up next year. We have pencilled in one 25bp rise to 1.00% in May 2021. This is some way above the current market expectation for rates to fall below 0.50% early this year and stay there until the end of next year.

Will the next move in interest rates be up or down?

This Focus is an adapted version of a presentation given at the Capital Economics UK Forecast Forum held in London on 21st January 2020.

This Focus looks at how the Bank of England will juggle two key issues, namely the negotiations around the UK’s new trading relationship with the EU and the impact of the forthcoming fiscal stimulus. It also assesses whether the Bank will fear a resurgence in inflation and what, if anything, the Monetary Policy Committee (MPC) can learn from the US Fed’s recent experience.

Pressure grows to cut rates

As well as developments in the economic data, the Bank of England’s latest monetary policy guidance states that, if Brexit uncertainty remains entrenched or global growth fails to stabilise then the MPC will cut interest rates. But it also says that if neither of those things happen and the UK economy recovers, then the Committee will probably need to modestly raise interest rates. In other words, the MPC has helpfully told us that the next move in interest rates will be either up or down!

The markets are clearly leaning towards the latter. Investors’ expectations for the future path of interest rates have changed dramatically since the start of 2019. A year ago, the markets were pricing in about two 25bp rate hikes, but they are now pricing in a 25bp cut by the spring and a 35% chance of a further 25bp cut by this time next year. (See Chart 1.)

Chart 1: Market Expectations for Bank Rate Implied by OIS Rates (%)

Sources: Bloomberg

It is easy to see why. There is clear daylight between the current rate of GDP growth and our estimate of its potential rate. (See Chart 2.) CPI inflation remains well below its 2% target and core inflation – that is inflation excluding the volatile energy, food, alcohol and tobacco components – has remained benign.

Chart 2: GDP Growth & Inflation (%)

Sources: Refinitiv, Capital Economics

Other indicators, such as the activity PMIs, have also fallen into the territory where rates have been cut before. (See Chart 3.) There is a strong relationship between the all-sector PMI and changes in interest rates. Indeed, on nearly all the occasions when the all-sector PMI has fallen below the horizonal axis, the MPC has cut interest rates within a few months. The only time the Committee didn’t cut rates was between 2011 and 2013, when the MPC was loosening policy using other tools instead. This may be significant again now, as the PMI fell to 48.9 in December, a level often associated with rate cuts of about 50bp. This suggests that it would be entirely consistent with their past behaviour for the MPC to lower interest rates in the coming months.

Chart 3: Change in Bank Rate & All-Sector PMI

Sources: IHS Markit, Refinitiv

Little wonder, then, that two of the nine members of the MPC voted in November and December for rates to be cut immediately. The past twelve times when that has happened, rates have been cut on ten occasions in the next three meetings. Only twice have rates remained unchanged. (See Chart 4.) And the multitude of comments over the past few weeks have suggested that other MPC members are becoming more open to the idea of cutting rates, perhaps even as soon as the Committee’s next meeting on 30th January.

Chart 4: Previous Rate Cuts After Two MPC Members Vote for Cut

Sources: Capital Economics, Bank of England

But a rate cut is likely to be avoided…just

Of course, the primary reason why most MPC members did not vote to lower rates in December was because they wanted more time to judge whether the decisive election result has prompted a reduction in Brexit uncertainty and a subsequent turnaround in the data.

So the post-election data over the next few weeks will be crucial in determining whether the MPC is willing to take a leap of faith that the worst is behind us and keep rates on hold, or if it cuts rates as an insurance that there is more bad news to come.

But so far at least, there have been some reassuring signs of an improving economic picture. The tentative evidence of stabilisation, as well as the Phase One trade deal between the US and China, may have alleviated the MPC’s concerns about a further weakening in global growth. The strengthening in the OECD’s global leading composite indicator has provided some reassurance that global growth has bottomed out, reinforcing our view that the global economy will regain at least some momentum this year. (See Chart 5.)

The latest news on Brexit uncertainty has been encouraging too. According to the Bank of England’s Brexit uncertainty index – which tracks the proportion of firms that name Brexit as one of their top three sources of uncertainty – uncertainty waned in December. And December’s figure would be even lower if it only included the responses received after the election. (See Chart 6.)

Chart 5: OECD Composite Leading Indicator & World GDP (% y/y)

Sources: OECD, Capital Economics

Chart 6: Bank of England Brexit Uncertainty Index

Source: Bank of England

There have also been signs of improvement in the activity surveys. The election result appears to have given the headline services PMI a boost in December and prompted a marked improvement in the various forward-looking balances of the PMI survey. (See Chart 7.) Other indicators have shown similar signs of a turnaround. Deloitte’s December CFO survey showed the biggest increase in optimism in a decade. And according to the RICS housing market survey, new buyer enquiries rose in December to their highest level in four years.

Chart 7: IHS Markit/CIPS Services PMI (Balances)

Sources: Refinitiv, IHS Markit

We wouldn’t argue with the financial markets that there is a decent chance of an interest rate cut from 0.75% to 0.50%, perhaps at the MPC’s next meeting on 30th January. Provided, though, that the surveys continue to show signs of improvement, our hunch is that the MPC will sit tight and leave rates on hold.

Monetary policy tightening still some way off

At the very least, a tightening of monetary policy still looks a long way off. After all, it seems likely that lingering Brexit uncertainty will continue to keep a lid on GDP growth this year. Like us, the MPC has assumed that Brexit uncertainty will ease in the near term, but not fade altogether.

More generally, the Bank of England has now explicitly factored in the UK’s likely new trading relationship with the EU in its forecasts for the first time. It is now basing its projections on the assumption that the UK moves to a deep free trade agreement with the EU but that some customs checks and barriers to trade are introduced. For now, though, the Committee believes that this might hit demand and supply equally, so it does not think that it is relevant for monetary policy.

Fiscal stimulus

However, while the Bank of England has accounted for the latest Brexit developments, it has not fully factored in the coming fiscal stimulus. It has incorporated the 0.6% of GDP stimulus in 2020/21 announced in the September 2019 Spending Round. But it hasn’t included the additional fiscal stimulus worth 0.5% of GDP that we think will be set out in the Budget on 11th March.

On the face of it, then, there may be plenty of scope for inflation to rise more sharply than the MPC expects and for rates to be raised sooner rather than later. Indeed, the Bank already thinks that inflation will start to trend upwards from the middle of this year and breach its 2% target by 2022. (See Chart 8.)

Chart 8: CPI Inflation (%)

Sources: Bank of England, Refinitiv

This presumably partly reflects the Bank’s expectation that the rise in firms’ unit labour costs, from close to zero to around 3.5% over the last four years, will eventually be passed onto consumers in the form of higher prices. However, the rise in firms’ labour costs has not reached consumer prices yet, with firms partly absorbing higher costs in their margins instead. Indeed, services inflation – a proxy of domestically-generated inflation – has continued to trundle along at around 2.5%. (See Chart 9.) And with demand likely to be restrained this year to some degree by Brexit uncertainty, businesses may remain relatively cautious about raising their prices.

Chart 9: Unit Labour Costs & CPI Inflation (% y/y)

Sources: ONS, Capital Economics

What’s more, we suspect the MPC might conclude, like us, that the fiscal stimulus won’t provide an especially large boost to inflation, given the softening in activity and weak investment should mean that there is still some spare capacity in the economy.

International lessons

Indeed, the MPC may be wary about repeating the US Fed’s mistake of overestimating inflation and raising interest rates too far after the fiscal stimulus in the US in 2018. Inflation fell to 1.4% in early 2019 rather than remaining close to 2% after the fiscal stimulus as the Fed had assumed. (See Chart 10.)

Chart 10: US PCE Inflation & US Fed Forecasts (%)

Sources: Federal Reserve, Refinitiv

This may partly explain why it hiked interest rates four times in 2018 but had to turn around and cut rates three times last year. Interest rates are now nearly back at the level seen before the fiscal stimulus began. (See Chart 11.)

Chart 11: US Fed Funds Rate (%)

Source: Refinitiv

In any case, inflation is more sensitive to the exchange rate in the UK than in the relatively closed US economy. So even if the UK economy regains some momentum, the accompanying rise in sterling will dampen inflation and limit the extent of any interest rate rises. None of this is to say that the MPC won’t raise interest rates at all. But it does suggest that the Committee might be cautious about raising rates too far.

In light of all this, our best bet is that interest rates will stay on hold this year and at the start of 2021. Nonetheless, with the economy riding the wave of the fiscal stimulus and Brexit uncertainty fading, we suspect that the balance will shift gradually in 2021 away from a loosening bias and towards a tightening bias. We have pencilled in one 25bp rise in May 2021 to 1.00%. This is some way above the current market expectation for rates to fall below 0.50% early this year and stay there until at least the end of next year. (See Chart 12.)

Chart 12: Expectations for Official Interest Rates (%)

Sources: Bloomberg, Capital Economics

We would concede, though, that the risks around this view are probably skewed more to the downside. After all, our forecasts are dependent on the UK and the EU reaching a piecemeal agreement on their new relationship this year and a continued waning in Brexit uncertainty. If Brexit uncertainty were to persist or intensify, then it is easy to see a situation where rates remain lower for longer.

Conclusion

The MPC has said that the next move in interest rates will be either up or down. In fact, we suspect that this year, rates will neither go up nor down!

Admittedly, the MPC’s decision at its next meeting on 30th January rests on a knife edge. And if there aren’t any signs of improvement in the data in the coming week, rates could well be lowered from 0.75% to 0.50%. On balance, though, our hunch is that the economic data will continue to show signs of a turnaround, prompting the MPC to sit tight and keep rates on hold.

Further ahead, we think that rates will go up and that the financial markets have gone too far in expecting rates to remain below 0.50% for the foreseeable future. But we doubt the MPC will hike rates this year. Indeed, the MPC will not want to repeat the Fed’s mistake of raising rates too far, only to have to cut rates again further ahead. Instead, 2021 may be the year the markets are caught out by higher interest rates.


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com