Should the BOE push up interest rates?
Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.
Last week, the Governor of the Bank of England (BoE), Mark Carney appeared to be arguing in favour of pushing interest rates higher in the UK this year. During his press conference Carney referred to economic fundamentals which support the case for “sooner and somewhat greater extent” higher interest rates (currently at 0.5%).
Below we discuss the economic backdrop, and give you the consensus forecast view on interest rate expectations.
The UK’s net trade (exports minus imports) is benefiting from strong global economic growth. The global economy is expanding at its fastest pace in seven years. It is estimated that 90% of the world’s economies are growing at above-trend rates, making the expansion broad-based. It is also increasingly being driven by investment.
The backdrop of strong global activity is particularly helpful to the UK because sterling fell in anticipation of a difficult Brexit that has not yet taken place. This is making our exports of goods and services less expensive, boosting trade.
The chart below highlights Sterling’s steep depreciation against the US Dollar to a low of 1.2047 in the wake of the unexpected vote to leave the EU. Since hitting its low point in January last year, Sterling has now recovered back to pre-Brexit levels removing some, but not all the weakness in the Pound, which actually began back in 2014 when Sterling was at 1.7166 against the Dollar.
UK Sterling Value v US Dollar (Dollars per 1 Pound)
Source: Bloomberg, 15 February 2018
In terms of the strong global economic backdrop economists are now wondering if a case exists for raising interest rates now.
Whilst the trade picture is positive, the consumer demand outlook for the UK economy has weakened. The extent to which growth can accelerate from here depends on many factors. Structurally, population growth is important in the long-term and productivity growth has been targeted as important in the medium-term. In the short-term, output may be able to grow more quickly without inflation being kindled if available resources turn out underutilised i.e. such that there is enough ‘slack’ in the economy. However, domestic inflationary pressures are likely to come into focus as the economy moves from excess supply to excess demand. This is different from recent inflationary pressures, which have some relationship with sterling weakness importing inflation which are expected to ebb.
This week the BoE confirmed that inflation at 3%, which is above the BoE’s 2% target level, hence there is more scrutiny on interest rate levels.
Interest Rate Probabilities
Outside the confines of the Bank of England, market participants play a role by setting out what they think will happen to interest rates. The chart below indicates that around 65% of market forecasters expect a rate increase in May. However, we notice that this has fallen back since the recent market turbulence. The case for two rate rises by the end of 2018 appears to be most unlikely according to external forecasters.
Probabilities of UK Interest Rate Hikes
Source: Bloomberg, 16 February 2018
In conclusion, hard data appears to be in conflict. Inflation is above target, global growth is strong, but UK consumer demand has weakened. The matter remains in the hands of the Monetary Policy Committee of the BoE.