02 May 2018
It all seemed to be going according to plan for the Bank of England (BoE), as market expectations gravitated towards an interest rate hike in May, with an assigned probability of over 90 per cent . Since then, however, the probability of a UK rate hike next week has collapsed to less than 20 per cent (see chart), representing a substantial fall from the highs of late March.
My own view - posted in a blog in November following the first UK rate hike - was that this could be a “one and done” for this cycle, as the backdrop for further rate hikes faced significant headwinds. Namely a slowing economy, tough Brexit negotiations and the rise in inflation that was merely transitory (rather than structural) due to the currency impact. To be candid, we felt raising interest rates any further could be a huge policy mistake.
My out of consensus view looked even more unlikely as the BoE communicated in February that another rate hike may arrive sooner than expected. The rationale being that the UK was already growing above its meagre economic potential and so closing the output gap, as well as signs of wage inflation on the horizon.
As it happens, since February there have been clear signs that firstly, the UK is growing slower than they expected; highlighted by last week’s Q1 GDP, which showed the UK economy growing by the slowest quarter since Q4 2012 at a paltry 0.1 per cent, and yesterday’s weak manufacturing PMI print (53.9 versus 54.8 consensus) indicating that weak Q1 data may be extending into Q2. Secondly, the inflation picture looks more benign, at 0.3 per cent lower than their projections in February and while real wages have crept up, it is doubtful whether this is enough to boost consumer confidence.
So, having raised expectations (not for the first time either!), the BoE now find themselves in an unenviable dilemma of “damned if they do and damned if they don’t...”, a horrible predicament for any central bank to find themselves in. The situation in the UK precisely highlights the difficulty global central banks face with signalling rate hikes in the post-GFC era. Remember, it took twelve months before the US implemented its second rate hike in December 2016.
Patience is key for the BoE at this stage and I’d argue there are lessons to be learned from the US, where the Fed, despite the long pause, has subsequently raised interest rates a further four times with their credibility remaining intact. We think a pause from the BoE is appropriate, given the domestic backdrop and signs that the frothiness in global GDP may well have stalled, which should provide a supportive backdrop for UK fixed income assets.
Nevertheless, we approach next week unable to rule out a rate hike completely. A May hike would represent a policy mistake in my opinion and unless accompanied by a markedly dovish tone, would also raise questions about the BoE’s credibility which is just about intact… for now.
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