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Implications for UK monetary policy after inflation hits 3.0%


Sterling is being impacted by not only the progress of Brexit but also the prospects of Bank of England monetary policy. UK inflation plays into this as the headline CPI increased to 3.0%, a five and a half year high for September. Expectation has been increasing that the Bank of England will hike interest rates in November. However with all the uncertainty surrounding Brexit what are the implications of inflation hitting 3.0% for the Bank of England and UK monetary policy?

Will a rate hike really happen? Hitting 3.0% means that inflation is 0.1% away from Bank of England Governor Carney being required to write a letter to UK finance minister Chancellor Hammond explaining why inflation had moved more than 1% away from the 2% target. According to the Short Sterling Interest Rate swaps a November rate hike is almost entirely priced in, whilst there is also pricing for another hike in the summer of 2018 (seemingly August 2018) and another for late 2019. That would mean two rate hikes in the next twelve months, both BEFORE March 2019 which is the end of the Article 50 notice period for leaving the EU. Could it really be that the Bank of England would do this?

Earnings growth continues to lag CPI quite alarmingly. This morning’s data shows Average Weekly Earnings (ex-bonus) at 2.1% whilst CPI is at 3.0% and core CPI is at +2.7%. Even taking into account the fact that the Bank of England in its August Quarterly Inflation report suggested that the currency weakness was adding around 0.75% to inflation, this means that headline CPI would drop back to 2.2%/2.3% once the currency impact drops out. The Bank would be hiking with real incomes negative. With real GDP running at around 1.5% for 2017, the UK is lagging the growth seem for the EU and OECD. Whilst the dire scenarios predicted for a post-Brexit UK economy may not have materialised, this is hardly the backdrop for a credible hiking cycle to begin.

In June 2014, Mark Carney was likened to an “unreliable boyfriend” by Treasury Select Committee member MP Pat McFadden due to the mixed signals that Carney had been sending over a potential rate hike. Fast forward three odd years and Carney has been talking up the prospects of a rate hike again. However, this time it seems that there is an appetite on the MPC for a hike. It seems that with the erstwhile most dovish member of the MPC, Gertjan Vlieghe, also sounding off hawkish due to inflation, that the Bank of England is set to hike in November. Add in the already hawkish Michael Saunders and Ian McCafferty, along with Andy Haldane who appears to also be on the brink too, the balance looks set to hike in November. That is certainly what markets are pricing. Sterling has also been strong because of this in recent weeks. However is it too far ahead of itself?

The decision to hike is unlikely to be unanimous. Yesterday we heard comments from two new MPC members, sounding far more dovish. Dave Ramsden said that he was not close to voting for a hike as he saw little sign of inflation pressure building in Britain’s labour market. Also Silvana Tenraryo seemed uncertain noting that it was “very contingent on the data”. This cautious new presence on the MPC could help to rein in some of the more hawkish members.

From an inflation perspective it is notable that much of the inflation the UK is experiencing is on a goods basis. However, the UK is a services dominant economy (c. 80% of GDP is from the service sector). The table below shows that inflation is mostly being imported from food (much of which is imported) and travel (energy factors) costs. These are big import led inflationary factors, rather than factors driven by the domestic economy. If this is the case then inflation is likely to be transitory as currency related factors drop out of the comparatives.

Hiking interest rates by 25 basis points will curb inflation, whilst inflation is expected to peak around the 3.0% level in Q4 this year. The argument is that a 25 basis point increase unwinds the emergency rate cut following Brexit. However, can the Bank of England reasonably justify another hike next year as inflation starts to fall back towards the 2% target, whilst the country remains in the midst of Brexit uncertainty? The Bank of England has somewhat boxed itself in now with rhetoric over the prospect of a rate hike and if it does not move in November, Carney will be facing strong accusations than merely an “unreliable boyfriend”. The MPC will move up by 25 basis points at the next meeting on 2nd November. However, my expectation is that it will be one and done.

However one and done would mean that the market is too far ahead on hiking expectations, as the Short Sterling swaps show. There may need to be an unwinding of this move. The 2 year Gilt yield has jumped by over 30 basis points from its September low of 0.14% and is trading for the past few weeks around 0.40%/0.50%. A hike in November seems to have been priced in.

Communication surrounding the rate hike could be key for expectations in 2018. If it is a “dovish hike” then this could ultimately prove to be sterling negative after volatility surrounding the announcement of a hike settles.

 


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