As we look forward to 2016, once again we are faced with the question of whether the Monetary Policy Committee (MPC) at the Bank of England (BOE)
will finally raise interest rates, or whether this will prove to be another year where expectations for a move in official rates are
to be dashed.
Now that we have confirmation of monetary policy divergence from the UK’s two largest trade partners, the eurozone and the U.S., the question of UK
monetary policy becomes ever more interesting. On the one hand the economy is continuing to perform well – growth is above trend, employment is at a record
high, the banking system has been restructured and public sector borrowing is moving back to more manageable levels. However, lingering doubts remain about
the path of inflation – the headline rate is hovering around zero, and underlying inflationary pressure still looks relatively weak. Given that monetary
policy acts with a lag, will the dominant influence at the MPC be skewed to slowing the economy as the output gap is eliminated, or will concerns over the
persistently low level of inflation win out?
The arguments for tighter monetary policy over 2016 are familiar ones. The domestic economy continues to perform well. As Andrew Balls and Richard Clarida
noted in their December 2015 cyclical outlook, we expect above-trend growth in the UK of 2%–2.5%, driven in large part by resilient consumer spending and
business investment. That in turn should spur further employment growth, and with the unemployment rate already just 5.1% we should expect some further
upward movement in wages as the pool of available labour shrinks. The last time that the unemployment rate was at these levels, wage growth was two
percentage points higher than the current 2.0% annual increase (Figures 1 and 2). For example, if we take the period from Q1 2001 (when the average
earnings series started) to Q1 2008 the unemployment rate averaged 5.1% and earnings averaged 4.3%. That would suggest that in time we should see stronger
wage growth than the current 2.0%, and, in fact, the BOE’s forecasts for wage growth for 2016 and 2017 are 3.75% and 4%, respectively (source: Bank of
England Inflation Report, November 2015). If that happens we should see inflation rise.
So what about the risks that inflation continues to undershoot? When looking at inflationary pressures, given that food and energy prices are set
internationally, it is often useful to look at inflation excluding these two sectors to get a sense of how much domestically generated inflation there is
in the economy. Here the news is still, at best, mixed. The consumer price index (CPI) excluding food and energy prices is just 1.4%. Additionally, the
recent levelling off in wage growth presents the risk that they do not rise as expected, and that the previous relationship between the unemployment rate
and wage growth no longer holds. In this case we could see subpar inflation for even longer than we expect.
So where does this leave the MPC, and what are the risks as we move through 2016? In the case of the BOE’s forecasts, it sees headline inflation rising to
1% by the end of 2016 and 2% by the end of 2017. Our own forecasts are currently in line with the BOE. The first thing to note is that the MPC is tasked
with delivering 2% CPI over the medium term, with a tolerance band of 1%–3%. For each quarter that the CPI deviates outside of the 1%–3% range, such as
now, the BOE Governor Mark Carney must write an open letter to the Chancellor of the Exchequer George Osborne detailing the causes of the deviation and the
route by which inflation will return to target. This is important, because at present the Governor remains in letter-writing mode, and yet the BOE’s own
forecast is that CPI will return to 2% by the end of 2017 and continue rising gently thereafter. So in theory, given the lags between a change in monetary
policy and changes in inflation, above-target CPI early in 2018 should encourage the MPC to tighten as early as the first half of 2016. However, it is also
likely that for much of 2016, we will see the Governor continuing to write letters to the Chancellor explaining why spot inflation is so low! Given that
inflation has persistently surprised on the low side, it would be a brave committee that hikes rates whilst the Governor is still writing letters
explaining the current inflation undershoot.
That suggests that the first minimum criteria to be met before any monetary policy tightening is a headline inflation rate back above 1%, and the BOE does
not see this condition as being met until late 2016. Alongside this, the MPC will also want to see some stronger underlying price pressures, preferably via
the core inflation rate going up, and some return of rising wage growth. In effect the MPC will want to see higher actual inflation and wage growth before
being comfortable with any monetary tightening. The challenges facing the MPC are akin to those of the ECB – namely a single target (inflation), which is
still stubbornly low. On the other hand the MPC faces the same challenge as the U.S. Federal Reserve, which is that while current inflation is low, given
the strength of the economy and the leads and lags involved in tightening, now would be a good time to consider tightening. That is why we expect the MPC
to sit on the sideline until late 2016 at the earliest, when they will have more data and the picture becomes clearer – in effect taking the
middle ground between the
ECB and the Fed.
When considering the implications for markets and the risks around MPC action, there are two data points worth noting. The first is that current market
pricing is for the MPC to start to raise interest rates in Q1 2017, with an additional 100 bps of hikes over the following three years. That would leave
Bank Rate at 1.75% by 2020. Whilst the cumulative cycle seems plausible, the start date seems late. That suggests that if we do see some upward movement in
core inflation and wages, the short end of the UK market is vulnerable. At present we would rather reflect this in portfolios as a yield curve exposure
rather than an outright underweight given the likely cumulative hiking cycle and the steepness of the curve.
As ever there are risks around any central expectation. In particular the second half of 2016 is likely to see the UK Referendum on membership in the EU.
At present the polling suggests a close vote, and whilst our central expectation is for a vote to remain in the EU, there is clearly a significant chance
that the vote goes the other way. Given the uncertainty that would ensue, it would be hard to see the MPC embark on a tightening cycle at or around the
referendum, especially if the vote is to leave. The “risk premium” surrounding the vote and the stubbornly low level of inflation explain the low level of
UK government bond yields across the curve. However, until we have greater clarity it seems unlikely that we will see a major revision to the overall level
of the market. Just as with the stance of monetary policy, bond yields sit somewhere between U.S. “risk-free rates” and eurozone “risk-free rates”. In
effect both the market and the MPC are caught between two opposing forces – econometric models suggesting that the downward pressure on inflation will
abate in time, in which the prudent policy response would be a gradual tightening of monetary conditions, and the hard data suggesting that prior
growth and inflation may be less robust, which would warrant caution on a policy tightening cycle. Fortunately this set of circumstances affords the MPC
time to see how the economy evolves before acting. Our expectation is still that in
due course we will see higher
UK interest rates, but the countervailing forces should not
be dismissed. Yield curve positions favouring intermediate bonds should deliver better risk-adjusted returns than outright duration in this environment,
whilst low interest rates and resilient growth should remain supportive of high quality credit.