There has been a striking shift in recent Bank of England (BoE) communication. In the minutes of its September meeting, policy makers noted that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months.” This message was then reiterated in speeches by noted ‘dove’ Gertjan Vlieghe and Bank Governor Mark Carney. In response, investors have drastically revised their expectations for the timing of the first rate hike since 2007 from several years away to perhaps as soon as November. What has caused this major shift in the Bank’s tone, and how is policy likely to evolve from here?
One possibility is that this is all idle talk, perhaps designed to give sterling a boost, tightening financial conditions, by misleading investors. It is true that the BoE has not always followed through on its policy guidance. In July 2015, Carney hinted at a rate hike “around the turn of [the] year”. Instead, the Bank kept policy on hold until August 2016, when it then cut rates in the aftermath of the Brexit referendum. Following this cut, the Bank suggested that further easing before the end of 2016 would likely be required. Policy was left unchanged for over a year.
Issues of credibility
There is nothing necessarily wrong with policy makers changing their minds as the economy evolves. True credibility ultimately comes from doing the right thing to meet your objectives, not following through on guidance that may no longer be appropriate. Nonetheless, the recent switch in the Bank’s communication has been so dramatic that it may struggle to influence financial conditions through future communication if it fails to deliver on its guidance this time. Furthermore, failure to deliver on a hike will see the recent tightening of financial conditions rapidly unwind, leaving the Bank back where it started. So it is hard to see what is gained by sending a deliberately misleading message.
So we should probably take the Bank at its word and expect a hike in the very near future. The question then becomes whether this is merely reversing the rate cut announced after the Brexit vote, or the start of a more substantial hiking cycle. To answer this question, we need to understand why the Bank has decided to tighten policy.
What is motivating the Bank?
The UK economy has certainly performed better since the Brexit referendum than the Bank initially forecast. Employment growth has been strong and unemployment has fallen to multi-decade lows, while stronger global growth should also help support the UK. So it may be that the Bank has decided that the strength of demand in the economy justifies tighter policy, especially as inflation is nearly one percentage point above the Bank’s 2% target. This would be a “good” reason to hike, in the sense that it is driven by a more optimistic economic backdrop.
Unfortunately this does not seem to be what is motivating the BoE. Despite the fall in unemployment, growth in cash wage growth has been extremely sluggish. The failure of wages to keep up with the spike in inflation has seen household spending power eroded and is weighing on consumption. Uncertainty around the Brexit process has held back investment spending, and exports have failed to contribute materially to economic growth. Inflation is above target, but this is entirely a consequence of the fall in sterling, and will start to drop out of the data in time. So it is hard to make a case that a stronger UK outlook justifies tighter policy.
Even the relatively meagre growth the UK is experiencing may soon start to exert upward pressure on inflation.
The real issue is that even the relatively meagre growth the UK is experiencing may soon start to exert upward pressure on inflation. This reflects the damage done to the UK’s supply side (its productive potential). As Vlieghe put it, “despite a clear weakening of GDP growth in the first half of this year, the amount of economic slack continues to be eroded.” Put another way, the rate at which the UK economy can grow without generating inflation has fallen.
Damage to productivity
As Carney outlined in his speech, there are a number of reasons to think the UK’s supply side has been damaged. The Bank estimates that by 2020 the level of investment will be 20% below its pre-referendum forecast, as uncertainty deters firms from investing in certain projects. This slows the growth in the capital stock, which is a key input to long-run potential growth. Furthermore, some of the UK’s existing capital stock tied to productive processes based on European Union (EU) membership will be made obsolete by Brexit. Resources that could have been used to add to the capital stock will have to be used instead to replace this capacity with new capacity that serves the UK’s new economic situation.
Any reduction in trade and global economic integration that stems from Brexit will also tend to weigh on productivity growth. Trade growth is strongly associated with improved productivity as it leads to better allocation of resources to countries and firms best placed to undertake the particular activity. The UK government has ambitions to use Brexit to build new trading relationships with the rest of the world, so may be that any loss of trade with the EU is replaced with new partners. In this case, the hit to the UK’s potential growth may end up being much smaller. However, even in the best-case scenario, it is hard to see this process of forming new trading relationships happening quickly, so Brexit will likely weigh on potential growth and the inflation outlook for some time.
The more concerned the BoE becomes about the UK’s productive potential, the more likely it is to deliver on more than one hike, as it needs to keep even modest demand growth in check. To be clear, the Bank may turn out to be wrong in its assessment of potential growth. In any case, the hiking cycle is likely to be extremely shallow given various global forces putting downward pressure on long-term interest rates. But for now it seems unlikely that the Bank will hike just once and then be done.