2nd July 2015
Steven Bell, economist at BMO Global Asset Management looks at whether the Bank of England will be forced to raise base rates this year…
Last month we took a look at the UK housing market and noted that there were signs that a mini boom was emerging with both house prices and rents accelerating. The trend in retail spending has also been strong. This acceleration in UK domestic demand will no doubt have raised some eyebrows within the Bank of England’s Monetary Policy Committee (MPC) but they may have taken solace in the near zero rate of inflation and the impending severe squeeze expected to be announced in the emergency Budget next month.
Let’s look at the evidence. Retail spending was broadly flat between 2009 and 2012, since then the trend has picked up to a buoyant 4.6% a year. With this trend now in its third year, we can reasonably talk of a UK spending boom.
The Bank of England is charged with controlling inflation, not retail spending. As headline inflation tumbled and wages remained subdued, they could take a relaxed approach to consumer spending. The wages picture has changed significantly. From 2011 until the middle of last year, wage growth averaged a very modest 1.3% a year. Since then it has picked up to 3.5% a year. The last three months has seen annualised growth of 4.5%. Rising wages boost inflation only to the extent that they exceed productivity growth.
Yet great uncertainty surrounds the prospects for UK productivity growth. The Bank of England take the view that productivity will gradually rise back to the previous trend rate of growth. If so, the 2% inflation target would be consistent with wage growth of 3.5%. If they are being too optimistic on productivity, or if wages accelerate further, they risk accommodating a damaging rise in inflation which would ultimately require a hefty increase in interest rates and raise the risk of recession.
Strong retail demand and rising wages are powerful forces pointing to an early Bank of England interest rate increase. But they are not the only factors. This month, the Chancellor will announce plans for a major fiscal contraction. This is expected to amount to 1% or more of gross domestic product (GDP). In normal circumstances, the MPC would wait to see the effect of this on the economy before moving on interest rates. The exchange rate is another factor that might cause the MPC to stay their hand.
The overall value of sterling, as measured by the Bank of England index, is now 7% above its average for 2014 and a full 20% above the low in March 2013. This appreciation represents a form of monetary tightening in itself, a market-driven alternative to a base rate rise.
These two important factors buy us some time but given the underlying trends in the UK economy, the MPC is likely to grow increasingly nervous as the autumn approaches. One factor that is frequently mentioned by some commentators as a reason for not raising interest rates is the current low level of inflation.
We disagree. Inflation was 5% in late 2008 when the MPC aggressively cut rates and in late 2011 when they kept them very low. Having looked through high inflation when circumstances suggested cutting interest rates, they will be equally willing to do the reverse.
So when do we think the first increase will be? A few weeks ago the market were pricing in no move before the end of 2016. Now they suggest a rise next May. We think the pressures for a rate rise will become intense before the end of this year. A least two members of the committee are likely to vote for a rise at one of the next two meetings. They could form the majority before the end of the year.