There are many interesting aspects to the current composition of the Monetary Policy Committee (MPC) at the Bank of England (BOE). One of the more striking ones is that no current member has been on the MPC at the time of a UK rate hike. Granted, individual members have voted to raise the official bank rate over the last six years, but they were without success in generating a majority. At present, the longest-standing member is David Miles, who joined the committee in June 2009, when the bank rate stood at 0.5% and the agreed amount of asset purchases stood at £125 billion. Since then, the UK CPI (Consumer Price Index, a common measure of headline inflation) has averaged 2.8%, and until this latest downturn in inflation, it had spent just six months (between June 2009 and November 2009) below the BOE’s 2% target. Meanwhile, the bank rate has remained at 0.5%, and the stock of asset purchases has risen by an additional £250 billion to stand at £375 billion.
Much of this period has been about looking through temporarily high inflation to support whatever recovery the UK economy could achieve. Now, however, we face a very different set of circumstances. Growth looks to be on a sustainable footing; however, rather than worry about above-target inflation, it looks very likely that the bigger concern is not just below-target inflation, but inflation hovering below the 1% lower tolerance band of the MPC’s target.
So, what should the MPC focus on: weak inflation or resilient economic growth? Is weak inflation signalling weak global demand, which will in turn slow our economy? Or will resilient domestic demand put sustainable upwards pressure on inflation? Encouraging growth outlook
The first point to note is that the outlook for UK domestic demand is still encouraging. Nominal wages in the UK finally seem to be ticking up, with the most recent monthly reading suggesting wages rose by 1.8% over the last 12 months (according to the Office of National Statistics (ONS), as of October 2014), which, when taking out inflation for the same month, provided real earnings growth of +1.3%, compared with -1.2% over the equivalent period 12 months ago. Employment intentions remain strong, suggesting that demand for labour is indeed getting to the point where wages can edge higher. Crucially, with further declines in food and energy prices likely, it seems likely that real wages can grow from a healthy combination of higher nominal wages and lower inflation. This trend should underpin domestic consumption despite the slowdown in the housing market.
While part of the story for domestic demand looks well-set to become fully entrenched, we do need to see business investment continue to pick up as this will in turn provide a healthier backdrop for productivity growth, and thus make wage gains more sustainable. This is good news, but tinged with a hint of uncertainty. The most recent data suggest that UK investment intentions are holding up well, as is actual business investment (see Figure 1) – both factors remain healthy in absolute terms and relative to previous business cycles.
There is, however, one caveat: The official business investment data is through the end of September 2014, at which point the Brent oil future was trading at around $95 (Bloomberg, as of 30 September 2014) rather than the current $51 (Bloomberg, as of 12 January 2015), and the FTSE was trading at £6,622 (Bloomberg, as of 30 September 2014), rather than the current level of £6,388 (Bloomberg, as of 14 January 2015). Thus, the recent weakness in markets, increased uncertainty about the global backdrop and negative European inflation prints are not reflected in this data. How significant the effect of these recent trends will be is undoubtedly of great consequence to the outlook for the UK.
The UK is an open economy, as reflected in its exports, which constitute 28% of total UK GDP (according to the ONS, as of September 2014). Therefore, the outlook for the global economy will certainly weigh on the UK’s economic performance. That said, the outlook for our main trading partners (Europe and the U.S.) is not materially more challenging than it was three months ago. Similarly, the UK should be a net beneficiary of falling oil prices, given that our trade balance in oil is ‒0.5% of GDP (according to the ONS, as of September 2014). This suggests that while the UK oil and gas sector will undoubtedly take a hit from the drop in oil prices, this should be outweighed by lower import prices and greater purchasing power for the consumers of oil (i.e., the general public). Given this development, there seems a good chance that business optimism will hold up sufficiently for businesses to continue to invest in future capacity (both capital and labour). What about inflation expectations?
This then brings us nicely to the outlook for inflation. UK CPI has already come down to just 0.5% (see Figure 2), below the 2% target for the MPC and below the 1% deviation from target that triggers an open letter from the BOE Governor to the Chancellor of the Exchequer explaining the reasons for the deviation and what actions, if any, are needed to bring it back to target.
While much of the recent fall in inflation is due to ‒ and will continue to be driven by ‒ lower food and energy prices, it is true that other components are also easing. However, this does not mean we are anywhere close to the point at which consumers start to hold back from purchases, the so-called deflation trap. Indeed, as we suggested earlier, our expectation is quite the reverse – consumers are likely to regard the fall in inflation as a welcome relief after years of negative real income growth.
It is also worth noting that, while headline inflation has been coming down sharply, more domestically focussed components of UK CPI have been more stable of late. We can break down the CPI into the traded goods sector, where prices are heavily determined by global factors (including the exchange rate), and the service sector, which by its nature tends to be more correlated with domestic demand (services are less internationally tradable, with haircuts being the textbook example). If we look at the service sector component of the CPI (see Figure 3), we see a slightly different story versus the headline CPI path: Although the service sector CPI has come down, it looks to have found some stability of late as UK domestic consumption has held up. In summary, our expectation is that consumers will regard the fall in inflation as a welcome respite from years of negative real income growth and make up for some lost consumption.
We think the first point to note is that there will be a cohort of the MPC who will not mind a bout of below-target UK inflation after several years of above-target inflation. It also gives them welcome breathing room during a period of uncertainty for the global economy, and one which we would expect them to make full use of. Given the current economic backdrop, the MPC has little incentive to change anything: On the one hand, the domestic economy looks to be holding up well, but on the other, there are risks from abroad, as well as uncertainty that could surround the UK general election (more on this in a minute) in May this year. As such, we should expect another period of inaction from the MPC. Investment implications
From an investment perspective, the outlook and recent trends suggest a number of conclusions. First, with short-dated bonds already at yields in line with the BOE’s bank rate, short-dated bonds offer little in the way of reward for the extra duration. Similarly, long-dated bonds at yields below 2.5% will struggle to rally further as yields become increasingly unattractive for long-dated investors to lock in. That suggests the best value is likely in the intermediate part of the yield curve, namely five- to 10-year bonds.
Where there is also scope for disappointment is in the UK inflation-linked bond (“linker”) market, where the implied inflation rate looks too high. In the longer end of the linker market, this is largely due to the structural excess demand; however, even in short and intermediate linkers, there is scope for disappointment. The breakeven inflation rate on 10-year linkers currently stands at 2.55%, while in longer linkers, it stands at 3.10% (according to Bloomberg, as of 13 January 2015). With breakeven rates much lower elsewhere (e.g., the U.S.) and the year-over-year Retail Prices Index already below 2%, there will likely be a better entry point for UK linkers. The waiting game
The final point we should also note is that in four months’ time, the general public will go to the polls to elect the next UK government. At the moment, there is such a wide variety of possible outcomes that forecasting the election result is very hard. It is very plausible that either of the UK’s main parties could win a workable mandate, although each comes with potentially different political outcomes, especially with regards to the country’s membership in the European Union. While the MPC would never admit it, this is just another reason for it to sit on the sidelines. Let’s just hope UK businesses do not do the same.