Last Thursday’s decision by the Bank of England, to keep interest rates on hold at 0.75%, was one of the more finely balanced announcements in recent years. With many having expected a valedictory rate cut by the outgoing governor Mark Carney, it also created a conundrum for his successor. Andrew Bailey, the former chief executive of the Financial Conduct Authority (FCA), will take the Bank’s helm from 16 March. He will do so amid a lively debate about the future direction of UK monetary policy.
Admittedly, looking at voting numbers alone, Thursday’s decision did not appear to be a close call. Members of the Monetary Policy Committee (MPC) voted against a rate cut by seven to two. But this masks the fuller picture: in the run up to the meeting, four out of nine MPC members indicated that they were leaning towards cutting rates. As a result, the market-implied probability of the Bank Rate being slashed rose to 70% on 17 January.
The doves certainly have a point. Recent data on GDP growth and retail sales have not been encouraging. The third quarter of 2019 (the last one for which figures have been published) saw the UK economy grow by only 0.4%, following a contraction of 0.2% the previous quarter. Retail sales growth also languished at 0.9% – a disappointing level for the UK at any point, but particularly so during the Christmas period. At the same time, inflation is subdued at 1.3%, far below the Bank’s 2% target.
The MPC is frequently (and often unfairly) criticised for overreliance on “backward looking” data, but in this case the “forward looking” metrics paint a similar picture for growth. Noting that it no longer expects any significant improvement in productivity, the Bank’s forecasts now indicate that the economy can only grow at an annual rate of 1.1% over the next three years without overheating. And this is not Brexit-related pessimism: the Bank’s model is predicated on the assumption of a smooth transition to a free trade agreement with the EU at the end of 2020.
So why were rates kept on hold? For a start, not all the data is gloomy. At 3.8%, unemployment remains at its lowest level since 1975. As a result, wages are picking up, with average weekly earnings growing at an annual rate of 3.2%, almost 2% above current inflation levels. This may well produce its own inflationary pressures. Without an increase in productivity, companies may eventually pass their increased labour costs on to consumers in the form of higher prices.
More importantly, the political environment suggests that the economy may be in for a boost. Surveys following December’s decisive election result suggested that business confidence had surged. When Sajid Javid, the chancellor, unveils the new government’s first budget on 11 March, it is widely expected that he will loosen the fiscal taps. The Conservatives’ manifesto included plans to increase capital spending by £20 billion, with a particular focus on infrastructure aimed at reducing the regional productivity gap. Higher spending on public services and environmental projects may also feature – amounting to a significant fiscal stimulus that may eliminate the need for looser monetary policy.
All in all, the incoming governor will have a lot to take stock of in the week and a half between his first day in the job and the next MPC meeting. So will market participants: Bailey has not previously sat on the committee, and his views on the current debate over inflation targeting, negative rates and interest rate normalisation are largely unknown. As it stands, the market still expects the doves to win out in 2020, with a 75% implied probability of one or more rate cuts before the year end. But, as recent experience has shown, that could change very quickly.
By Josh Roberts, Associate Director at Chatham Financial (formerly JCRA)