A loosening bias emerging - Capital Economics
UK Economics

A loosening bias emerging

MPC Watch
Written by Andrew Wishart

Unless the headwinds of weak global growth and Brexit uncertainty fade, the next move in interest rates may be down. But the chance of a Brexit deal in January means the majority of the Committee will probably decide it is premature to act at the meeting on Thursday 7th November and leave rates on hold at 0.75%.

  • The economy may be on a path that would eventually prompt the MPC to cut rates…
  • …but the chance of a Brexit deal in January will keep the toolbox in the closet for now

Unless the headwinds of weak global growth and Brexit uncertainty fade, the next move in interest rates may be down. But the chance of a Brexit deal in January means the majority of the Committee will probably decide it is premature to act at the meeting on Thursday 7th November and leave rates on hold at 0.75%.

Trimming the forecast

Back in August, the Bank of England’s forecasts painted a hawkish picture, with inflation above target at the two-year horizon. However, the projections were distorted by a sharp fall in interest rate expectations due to fears of a no deal Brexit. In reality the MPC became more dovish, and hinted interest rates would only need to rise to 1% if there were a Brexit deal as opposed to 1.25% previously.

This time the Committee and the Bank’s forecast published in the accompanying Inflation Report are both likely to take a dovish turn.

The Bank expects the £13.8bn (0.6% of GDP) increase in government spending announced in the 2019 Spending Round in September to lift GDP by 0.4% over the course of the next three years. In the Bank’s model, that stronger demand will work its way through to inflation, perhaps adding 0.2ppts in 2021.

But everything else is pulling in the other direction. Soft GDP growth has confirmed the Committee’s expectation that there would be a little slack in the economy in Q3. (See here.) And annual GDP growth of 1.1% in August was below the MPC’s 1.4% judgement of potential. If anything, growth has undershot the Bank’s August expectation. While it might have been a touch higher in Q3 than the 0.3% q/q increase that the Bank anticipated, the 0.2% q/q fall in Q2 was worse than the Bank’s expectation that the economy stagnated. (See Table 1.)

Table 1: Data Background

Assumption in August Inflation Report / September MPC Minutes

Latest Developments

Demand:

  • GDP growth of 0.0% q/q in Q2. 0.3% q/q in Q3.
  • Weaker than expected: GDP growth is likely to exceed 0.2% q/q in Q3 but fell by 0.2% q/q in Q2.
  • Quarterly consumption growth expected to average 0.25%.
  • Stronger than expected: Consumption grew by 0.4% in Q2 and strong retail sales growth suggests it had a good Q3.
  • The UK house price index to rise by just over 2.0% in the year to Q1 2020.
  • Weaker than expected: House price growth in the year to August was 1.3%.

Labour market:

  • Unemployment rate to remain around 3.75%.
  • Weaker than expected: The unemployment rate was 3.9% in the three months to August.
  • Four-quarter average earnings growth to average around 3.5%.
  • Stronger than expected: The headline measure of average earnings growth was 3.8% in August.
  • Quarterly hourly productivity growth to be ¼%.
  • Broadly on track: We estimate productivity fell by 0.2% q/q in Q2 but will rise by 0.6% q/q in Q3.

Inflation:

  • CPI inflation of 1.7% in September and 1.6% in Q4.
  • On track: CPI inflation was 1.7% in September.
  • Sterling TWI to average 76 in 2019.
  • Stronger than expected: Sterling TWI has risen to 79.
  • Indicators of medium-term inflation expectations to remain broadly consistent with the 2% target.
  • Broadly on track: Household and market inflation expectations are well anchored, consistent with 2% inflation.

Sources: Bank of England, Refinitiv, Capital Economics

The latest evidence is that slack has continued to open up in the economy. Measures of capacity utilisation in firms have come off the boil, and the number of unfilled vacancies is falling. (See Chart 1.)

Chart 1: Indicators of Economic Slack

Source: Refinitiv

The delay to Brexit until 31st January suggests spare capacity will continue to open up. In August the Bank expected GDP growth to be soggy between now and mid-2020, and average just 0.25% per quarter. The further delay to Brexit might lead the MPC to judge that uncertainty will stay high for longer, pushing back the point at which growth picks up.

Global growth could also be revised down. The Bank thinks growth in the UK’s trade partners will tick up in 2020, whereas we suspect it will slip back. The continued weakness of the global PMI might nudge the Bank closer to our own judgement.

Moreover, a rise in the pound, a fall in oil prices and a slightly higher interest rate assumption will all conspire to pull down on the Bank’s new forecasts for growth and inflation compared to August, particularly in the near term. The GDP and inflation forecasts will probably be revised down in 2020. In particular, the inflation forecast might be curtailed from 2.1% to 1.7% at the end of 2020. But the Spending Round stimulus will boost the forecast further out, keeping the Bank’s forecasts for GDP and inflation more or less unchanged at 2.3% and 2.2% respectively in 2021.

Brexit scenarios and distortion

Above-target inflation at the two-year horizon suggests that the MPC should be thinking about hikes. Note, though, that the Bank’s forecast is flattered somewhat by the assumption that interest rates follow investors’ expectations for a cut in 2020 (see Chart 2), whereas the MPC suspects it would have to raise rates if there was a deal.

And crucially the forecast is based on a “smooth adjustment to the average” of possible post-Brexit trading relationships with the EU, i.e. a deal. In that case, the Bank expects uncertainty would fall back and growth would accelerate.

Chart 2: Expectations for Bank Rate Implied by OIS (%)

Source: Refinitiv

However, the Bank has increasingly acknowledged that it is forecasting a scenario that may not come to pass. In the September minutes, it hinted how it expects the economy to perform if Brexit is repeatedly delayed instead. In that case, the MPC said that growth would remain soft and “domestically generated inflationary pressures would be reduced”.

With Brexit delayed for three months to the end of January, Brexit uncertainty isn’t going away. And the Bank’s own work suggests that short delays are particularly harmful to activity because they tempt firms and consumers to hold off spending plans until the uncertainty is resolved. What’s more, we think there is around a 45% chance Brexit is delayed yet again beyond January. (See here.)

So rather than heading towards a deal, the economy could be heading for further delay, which may require looser policy.

Doves hiding in the birdhouse?

External members Michael Saunders and Jan Vlieghe have both gone a step further than the September minutes, saying looser policy would be appropriate if Brexit uncertainty persists.

And Saunders has said he would vote for lower interest rates if the economy requires it, even if a Brexit deal thereafter means the MPC has to reverse course later. (See Table 3.) Paired with his judgement that the output gap is widening, we think there’s a good chance he will vote for a cut in November and Vlieghe may join him.

The rest of the MPC has been pretty much silent on monetary policy since the September meeting, so it is impossible to know how much this dovish sentiment has spread. But seeing as Saunders and Vlieghe are the most proactive members of the Committee, it wouldn’t be unusual for the pair to be the only dissenters. Saunders has been a lone dissenter in five meetings during his time on the MPC, advocating hikes ahead of the two that eventually came, and Vlieghe led the way in voting for the post-referendum cut.

Chance of a deal will prevent a cut

We suspect the other members will find reasons to hold off pulling the rate cut trigger. Most importantly, a deal could be just around the corner. If the Conservatives convert their poll lead into a majority (unlike in 2017) the deal should be passed by January. So long as businesses aren’t concerned about something like a no deal in December 2020, when the transition period ends, that should lead to a pick-up in growth. (See here.) Both we and the Bank forecast GDP growth of over 2% in 2021 if there is a deal, well above the 1.4% that represents overheating according to the MPC.

Second, the MPC might want to hold off cutting interest rates until after the 12th December general election to avoid any (unjustified) suspicion of the Bank being politically motivated. It has another chance to adjust policy on 19th December. (See Table 2.)

One final consideration is the upcoming change in the Governor. If the Committee doesn’t feel a pressing need to alter policy, it may bide its time until the new Governor is due to take their place on 1st February. Paul Tucker, previously deputy Governor for Financial Stability and favourite to replace Mervyn King back in 2013 has jumped up the list of contenders. That said, the announcement appears to have been delayed until after the election, making 1st February a tight (and perhaps unattainable) timeline for getting the new Governor in place.

The upshot is that interest rates will remain unchanged at 0.75% next Thursday, but the decision will probably be split with the one or two of the most proactive members advocating a cut.

Looking further ahead

If Brexit continues to be delayed, and Michael Saunders does vote for a cut, he may yet again prove a bellwether for interest rates. Indeed, if Brexit is delayed beyond January, we think the MPC would cut rates in Q2 next year in line with investors’ expectations. If the economy struggles in Q4, there is a chance policy is loosened earlier.

On the other hand, a deal might cause a reassessment of market rate expectations. Much depends on how much a deal reduces uncertainty for businesses. But in a scenario where investment rebounds and the economy gets a kick from a further loosening in fiscal policy we suspect the MPC would hike rates towards the end of next year.

With the chances of a no deal diminished, the main risk is that interest rate hikes following a deal catch investors out.

Table 2: MPC Meeting Outcomes & Forecast (Repeated Brexit Delays Scenario)

Date

Outcome/Forecast

Date

Outcome/Forecast

7th Feb. 2019

0.75%

30th Jan. 2020*

0.75%

21st Mar. 2019

0.75%

26th Mar. 2020

0.75%

2nd May 2019*

0.75%

7th May 2020*

0.50%

20th Jun. 2019

0.75%

18th Jun. 2020

0.50%

1st Aug. 2019*

0.75%

6th Aug. 2020*

0.50%

19th Sep. 2019

0.75%

17th Sep. 2020

0.50%

7th Nov. 2019*

0.75%

5th Nov. 2020*

0.50%

19th Dec. 2019

0.75%

17th Dec. 2020

0.50%

Sources: Bank of England, Capital Economics. For details of our forecasts in deal and no deal scenarios, see our UK Economic OutlookOutlook softer whatever happens with Brexit”, 14th October 2019.

Table 3: Summary of MPC Members’ Views (Members ordered from most dovish to most hawkish)

Member

Term End

Previous Vote

Past Non-Consensus Votes

Recent Key Comments

Michael Saunders
(External Member)

Aug. 2022

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted to raise rates in Jun.-Sep. 2017 and Mar.-Jun. 2018.

If there is prolonged Brexit uncertainty “it might well be appropriate to…loosen policy at some stage, especially if global growth remains disappointing.” “I would prefer to be nimble, adjusting policy if it appears necessary to keep the economy on track, and accepting that it may be necessary to change course if the outlook changes significantly.” (Speech in Rotherham, 27th Sep.)

Gertjan Vlieghe
(External member)

Sep. 2021

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted to cut rates in Jul. 2016, while the other 8 members voted to keep rates on hold.

“A near-term Brexit deal…might yet stimulate investment sufficiently to prevent the need for easier monetary policy, and put gradual and limited rate hikes back on the agenda, eventually. A scenario of entrenched Brexit uncertainty is likely to keep economic growth below potential, and require some…stimulus.” (Speech in London, 15th Oct.)

Jonathan Haskel
(External member)

Sep. 2021

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

None.

“Just because there has been a reasonable amount of wage pressure…does not mean it is necessarily going to go on in the future. [Firms] are generally pessimistic about output growth. If that feeds through to the labour market, and there are some signs of that, I might expect those labour costs to come down a little bit… (Evidence to Treasury Committee, 4th Sep.)

Silvana Tenreyro
(External member)

Jul. 2020

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

None.

“I still expect that in a smooth Brexit scenario, a small amount of policy tightening will be required… Recent developments likely lengthen the period until there is a sufficient pickup in inflationary pressures for me to vote to raise Bank Rate.” (Speech in London, 10th Jul.)

Sir Jon Cunliffe
(Deputy Governor – Financial Stability)

Oct. 2023

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted against raising rates in Nov. 2017.

“Pay growth [is] in the 2.5-3% range. But the latest readings do not signal strongly that pay growth will make the step to establish itself firmly in 3% territory… We may be underestimating supply in the labour market.” (Treasury Committee Questionnaire, 17th Oct 2018.)

Ben Broadbent
(Deputy Governor – Monetary Policy)

Jun. 2024

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted against QE extension in Jul. 2012.

“Were the economy to develop in line with our projection . . . interest rates would probably have to rise by a little more than what was in the curve at the time of the May forecast.” (Treasury Committee, 12th Jun.)

Mark Carney
(Governor)

Jan. 2020

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

None.

Asked if securing a Brexit transition meant the BoE would resume raising rates, Carney said: “Not necessarily. I’m not going to pre-commit, there is a lot of contingencies there.” (Bloomberg TV, Washington, 18th Oct.)

Sir Dave Ramsden
(Deputy Governor – Markets & Banking)

Sep. 2022

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted against raising rates in Nov. 2017.

“From my perspective, I also think spare capacity might not have opened up that much despite that weakness in underlying growth, because I think supply potential…is also slowing through this period. That comes through for me pretty clearly in the latest productivity numbers.” (Telegraph Interview, 13th Oct.)

Andy Haldane
(Chief Economist)

Jun. 2020

Rates: 0.75%

Gilts: £435bn

Corp. bonds: £10bn

Voted to raise rates in Jun. 2018.

“My personal view is that I would be cautious about loosening monetary policy, barring a sharp downturn in demand in the economy. Despite slowing, underlying UK growth remains only a little below potential and the labour market remains tight.” (Evidence to Treasury Committee, 4th Sep.)

Sources: Bank of England, UK Parliament, The Telegraph, Bloomberg.


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com