15 May 2018
The Bank of England voted 7-2 to leave Bank rate on hold at 0.5% last week. This is a significant turnaround from where we were a month or so ago, when a hike was nearly 100% priced. However, a run of mixed data and a pointed intervention by Governor Carney caused the market to largely rule out a move. The Bank essentially endorsed the existing market pricing of three hikes over three years, projecting inflation back to 2% two-to-three years ahead on the basis of this profile. With uncertainty currently elevated, the Bank seems not only data dependent, but also highly data sensitive, and the majority of the Monetary Policy Committee (MPC) wants to wait until it becomes clear that Q1's soft patch was genuinely only temporary before raising rates further. Without strong conviction in the outlook, the Bank is less inclined to simply dismiss and look through temporary deviations from its forecasts.
GDP growth for this year was revised down from 1.8% to 1.4%, reflecting the weak start to the year. However, the MPC expects Q1 growth to be revised up to 0.3% in time, as it believes survey data is consistent with a higher rate of growth than the 0.1% estimate from the ONS. Indeed, the Bank is convinced that the ONS systematically understates GDP growth in its initial estimates. The fundamentals that underpin the Bank's forecasts were largely unchanged. It sees: unemployment already slightly below its 4.25% estimate of the natural rate of unemployment; potential growth of only 1.5%; and "very limited" existing spare capacity. With productivity growth so slow, even quite modest wage growth can represent an increase in unit labour costs and upward pressure on inflation. Productivity growth has actually recently shown some signs of coming back to life, posting two strong quarters of growth. If this trend continues, the Bank will need to revisit its fairly pessimistic view of the supply side (see Chart 4). For now, the Bank's forecast of the evolving supply and demand balance necessitates a "gradual and limited" hiking cycle.
The most significant forecast change was on the pass-through of sterling depreciation into inflation (see chart 5). The Bank is now forecasting slightly less pass-through, reflected in a slightly lower inflation profile with price growth coming back to target sooner than previously expected. The declining impact of sterling's depreciation on inflation means the Bank no longer believes it faces the same pressing trade-off between stabilising growth and inflation. It is now setting policy to bring inflation back to target over the "conventional horizon" of two years, rather than the three years it had been working to previously. Overall, we maintain our forecast for a hike in August, followed by two more hikes next year. This is predicated on our expectation that Q1 weakness in the UK (and the Eurozone) will be largely temporary, and the recovery in activity will be sufficient by August to give the Bank comfort to hike. However, we note that the risks to this forecast are now skewed to the downside, with the possibility that households will use the opportunity provided by the end of the real wage squeeze to start to boost savings. The Bank has shown itself particularly sensitive to incoming information, which could lead to the perception of confused signalling and communication in the run-up to August.