Fundamental Macro

While a couple of weeks have passed since the BoE released the February Inflation Report, I thought it was still worth looking back at the salient points, and the messaging that has followed.

The most significant message in the Inflation Report was that the Bank made explicit that it would “look through” the one-off falls in energy and food prices (ie there was no desire to ease policy in response) and instead focus on the outlook for inflation in 18-24 months time. Based on market rates prevailing at the time of the Report, the inflation forecast rose to 2% in two years and then a little further above two beyond that. That meant it was somewhat stronger than in the November 2014 Report, as was the GDP growth projection.

Prior to the more explicit attempts in recent years at forward guidance (let’s hope that doesn’t happen again), the Bank has traditionally used the inflation forecast as a guide to whether market pricing is a little too aggressive or not aggressive enough (in either direction). So with the Feb inflation forecast at target in two years time and a little above thereafter, a soft message is being sent to the market that expectations for the timing and pace of hikes is a little slow.

But digging below the surface a bit reveals some more interesting aspects of the forecast.

Gov Carney was clear in his opening remarks that three factors had boosted the domestic and global outlook since November:

1. Lower oil prices were seen as primarily supply-driven and therefore would be a net boost to real disposable income and consumption
2. Policy action had seen further stimulus added in several key economies, including the EA
3. Global real interest rates had fallen further

Despite these factors, the Bank’s global growth forecast was little changed, implying that there were other offsetting factors (indeed at least (2) and (3) were arguably a result of those factors). But even more interesting was the impact on UK domestic demand, which was only revised up a little. It is interesting because that was despite a quite substantial upward revision to real disposable income (reflecting the lower oil price). But rather than that being largely passed through into higher consumption growth, instead the Bank have revised up quite materially the forecast for household savings.

I suspect that they were probably a little worried that their consumption forecast already looked a bit ‘toppy’, and so made a top-down judgement to push it down relative to the normal model response to the oil price decline. They may well be right, but it is not something I heard come up in the press conference or elsewhere, and so is something to look out for in the coming months (and the May IR). It may be an easy route for them to find a little more growth and inflation should they feel the time to hike is getting nearer.

Which brings me to the question of timing of the first rate hike. At the time of the February IR, the first rate hike was not fully priced in until October 2016, with only two and half hikes priced through to mid-2018. When Carney started with the now famous “limited and gradual rate increases” language, I don’t think even he could have imagined so little being priced in over the next 3 years. But mis-steps in Bank communication (alongside external developments) have seen the first hike priced in as late as 2017 when Carney first joined the Bank, to November 2014 midway through last year, only to swing all the way back out towards the end of 2016 again.

But I think the position the Bank finds itself in is not dissimilar to the Fed. Growth has been robust, and above trend for some time now. It has eased a little, but remains decent. The labour market continues to tighten, and the degree of remaining slack is now small (the Bank estimate it to be 0.5%). They expect wage growth to start rising, and there are some signs in the official data that is starting to happen (ignore the surveys on this as they are rubbish). Indeed the Bank has recently said that the drag on wage growth from the rise in the number of low-skilled jobs is now starting to unwind, which could see wage growth boosted by at least 1% without any further tightening in labour market conditions.

If all of this happens, then pressure on “core” inflation (something that Bank tends not to talk so much about compared to its peers) is likely to increase and I believe the MPC will want to start the normalisation process.

In the past couple of weeks, we have heard the following from MPC members:

Forbes: “We shouldn’t let the headline inflation figure detract from the underlying strong fundamentals in the economy. That means we will need to start to think about normalizing interest rates. We don’t know when yet, and when will depend on the data, it will depend on what happens with wages.”

Weale: “Our recent forecast showed inflation rising above target by mid-2017. We expect that, in order to manage this, bank rate will rise gradually.”

Cunliffe: “The economy has been growing strongly and our forecast is for that to continue.”

All of which makes me think that the Bank is much more comfortable with the idea of a first rate hike later this year than what the market expects. I’m not sure that it will be as soon as August, when the new approach to communications begins, but I think if things turn out broadly as the Bank expects, that November is a strong possibility.