03 Feb 2017

BoE Inflation Report – Steady but (not quite) neutral

Philip Shaw

Chief Economist

Today saw the seventh so-called Super Thursday i.e. the concurrent releases of the Monetary Policy Committee decision, the minutes from the meeting and the Quarterly Inflation Report (IR).

  • The issue was not so much whether there would be a shift in the stance of policy today. Nobody, including ourselves, believed that to be a serious possibility. The key questions were the extent of the MPC’s upward revision to the economic outlook; if this had a material impact on the inflation projections; and whether the committee’s tolerance of a period of higher inflation had changed.

  • As widely expected the MPC kept policy on hold. The Bank rate was maintained at +0.25%, while the gilt asset purchase (QE) target was frozen at £435bn. Both votes were unanimous. Members also voted 9-0 to keep its target of the purchase of £10bn of corporate bonds. This was the last meeting attended by Deputy Governor for markets and banking Nemat Shafik, who departs the Bank of England shortly.

  • The minutes acknowledged that the economic outlook had brightened since the previous meeting in December. Indeed the IR formally upgraded the GDP projections to 2.0%, 1.6% and 1.7% for 2017-2019 from 1.4%, 1.5% and 1.6%, previously. This marks a shift from November’s IR when the MPC pushed up its near-term forecasts at the expense of lower growth in the longer-term. This time the level of GDP in three years’ time is predicted to be around 1% above projected levels last time. At his press conference, BoE Governor Mark Carney explained that half of this reflects looser fiscal policy announced at the Autumn Statement and more than a quarter due to better global growth prospects (on a ‘UK weighted’ basis). Two other supportive factors were easier credit conditions and higher equity prices.

  • Despite the growth upgrade, the BoE’s latest inflation projections were a touch lower than in November. The CPI measure is predicted to peak a little under 2.8% in 2018 (against a little above 2.8% previously) and expected to be at 2.4% in three years’ time, against 2.5% three months ago. The risks of inflation remaining higher than 2% (also in three years’ time) are also seen to be a little softer (60% versus 63%).

  • Bearing in mind the firmer growth background, it is worth asking how the MPC rationalises a small downgrade to its CPI projections. There are three reasons. First, the BoE has lowered its view of the equilibrium rate of unemployment to 4.5% from 5.0%, the equivalent of finding a little bit of spare capacity at the back of the sofa. To be fair, there is a decent rationale for this. There has not been a major increase in pay growth recently, although the jobless rate has fallen to 4.8%. Also, a decline in long-term unemployment has accounted for the lion’s share of the fall in joblessness over the past few years, suggesting that conditions in the labour market are effectively easier than previously believed. Second, sterling recovered by some 3% in trade weighted terms since November’s IR. Third, the yield curve steepened over the same period. Hence the forecasts were conditioned on a slightly higher path of interest rates (for example, a Bank rate averaging 0.6% in 2019, against 0.4% last time).

  • Although all three votes were unanimous for steady policy there was evidence of a modest hawkish shift across at least some of the committee. The minutes suggested that ‘some members’ believed that they were a little closer to the limit where they could tolerate above target inflation (Dr Carney’s recent speech ‘Lambda’ gave an excellent exposition of this topic).

  • Three key judgements which will sway the MPC one way or another will be; i) that the rise in inflation due to the lower pound does not have consequences for longer-term inflation expectations; ii) wage growth remains modest; and iii) consumer spending growth in real terms slows in response to the projected increase in inflation. Hence although the committee maintained that policy could be moved in either direction, the underlying message conveyed by the MPC leans more towards the possibility of a tightening at some stage. Indeed a key point is that inflation is projected to be above target for the entire duration of the forecast horizon. Our own view remains that the next move in the Bank rate will be a hike, albeit not until 2019. But if the economy continues to perform as resiliently over the next six months as the last six months, there could be more serious speculation of an increase by the end of this year.

  • Markets had geared themselves up for a hawkish report. Given that there was a relative absence of explicit tightening talk, sterling fell back by a cent against the US dollar to $1.2550, while euro:sterling moved up by 0.5p to 86p. Fixed income markets rallied such that medium-term expectations of 3m LIBOR softened by 5bps. The yield curve is now not fully pricing in the first 25bp rise in the Bank rate until autumn 2018.