Dropping anchor amid the Brexit fog

04 Feb 2019

George Brown


Bank of England Governor Mark Carney expected to announce rates will be held at 0.75%, but Inflation Report set to forecast a modest overshot of 2% target 

On Thursday 7 February, the Bank of England’s Monetary Policy Committee (MPC) is set to convene for its first meeting of 2019. Given the substantial Brexit uncertainty, our expectation is that policymakers will be firmly in wait-and-see mode.
We look for unanimous votes to leave Bank rate at 0.75% as well as to maintain the targeted stock of gilts and corporate bonds at £435bn and £10bn respectively. The policy announcement itself and updated Inflation Report (IR) projections are due midday, with Governor Mark Carney’s press conference following at 12:30pm.

Brexit ambiguity

Policymakers may well have the feeling of déjà vu, with the political stalemate yielding little progress by way of a Brexit ‘solution’ since the MPC last met in December. But while the current state of affairs is relatively unchanged, this masks a continually evolving situation in Westminster which poses sizable bimodal risks to the UK economic outlook.
In the face of this Brexit ambiguity, we expect the MPC to judge that the best course of action at this juncture is to simply sit on the sidelines awaiting further clarity.

Quarterly Inflation Report released

But as this will be a ‘Super Thursday’, the Bank will also provide updated economic projections in the form of its quarterly Inflation Report. Given the current political sensitivities surrounding Brexit, the Bank will probably be mindful of making any material changes to its growth forecasts.
At the same time, however, it will have to address the broad-based moderation in global economic momentum, having said in December that it appeared to be occurring “sooner than anticipated”. Subsequent data has done little to dispel this, while heavy European snowfall and the partial US government shutdown look set to depress global activity in Q1.
To our minds, this is likely to be a temporary phenomenon, but the MPC may well take an alternative view and bring forward its judgement of the cyclical turning point for a number of key economies.

Offsetting factors

Still, there are also set to be a number of offsetting factors to the deterioration in the external backdrop. Among these is the fiscal loosening unveiled in the 2018 Autumn Budget which the MPC estimated in December would “boost GDP by around 0.3%” over its forecast horizon.
Further support will come from a flattening in the SONIA curve, which is pricing in nearly one less 25bp rise in interest rates over the next two years than it was at the time of the last Inflation Report. Taking all of this into account, it is reasonable to assume that its updated forecasts for GDP growth may not look all too different to those from November.

CPI projections

Turning to the MPC’s CPI projections, these will, as usual, be based on the 15 working day average of various market pricing metrics. Aside from the aforementioned shift in SONIA, another upward influence on CPI is set to be the Brent oil futures curve which, after a marked selloff in oil prices, is now gradually upward-sloping as opposed to its previous downward profile.
At the same time, the effect of trade-weighted sterling should be more-or-less neutral given that it is broadly indifferent (1.0% weaker) to what the last forecast was conditioned on.

Labour market assumptions

But in any case, the most crucial determinant of the inflation forecast will be the Bank’s labour market assumptions. Since the MPC last met, the unemployment rate has edged back to 4.0% and both total and ex-bonus earnings growth have remained at post-2008 highs.
However, Bank analysis in December suggested some of the recent strength may partly reflect occupational and industrial mix effects and therefore may only prove transitory.
In fact, we are set to gain even further insight into the MPC’s view of the structural composition of the labour market in February as it is set to undertake its annual reassessment of supply-side conditions.
‘We suspect that the MPC will no longer forecast CPI inflation falling back to its 2.0% target over the next two years.’
As part of this, we will learn of whether the Bank has opted to revise its current 4.25% estimate of the ‘equilibrium’ rate of unemployment. Barring any major changes on this front, we expect the MPC will maintain the broad contours of its earnings assumptions and therefore will probably still judge that domestically generated inflationary pressure poses a risk to the medium-term inflation outlook.
In addition to the shifts in SONIA and Brent futures, we suspect that the MPC will no longer forecast CPI inflation falling back to its 2.0% target over the next two years, but will rather foresee a modest overshoot.

Further rate rises expected

Consequently, our expectation is that the MPC will still continue to judge that further rate hikes are necessary. We have pencilled another 25bp hike in for May, but caution that this is highly dependent on the timing of Brexit as well as the eventual form in which it takes.
Subsequently, we look for two further hikes across successive six month periods until Bank rate reaches 1.50% in May 2020.

Speculation over Federal Reserve policy

But while the policy obstacle of Brexit should hopefully be resolved by next year, it could well be superseded by a global reversal in policy direction by central banks. For one, there is mounting speculation about when the Federal Reserve’s FOMC will embark on its next easing cycle now that it is signalling a pause in tightening.
Our base case for two 25bp hikes in 2019 appears vulnerable as a result. If a rate-cutting scenario materialises next year, as some expect it might, it will be interesting to see whether this has a knock-on effect on the MPC’s own normalisation plans.