Stronger growth could see rates rise as early as May.
The Bank of England’s Monetary Policy Committee (MPC) voted unanimously to keep interest rates on hold in its meeting yesterday, but the vote was accompanied by concerns that the UK economy is running out of spare capacity. The increase in the policy rate in November last year by 25 basis points, which signalled the start of a gradual tightening phase for the UK central bank, could therefore be followed with further rises as early as May this year.
Inflation appears to have peaked at 3.1% in November, as the effects of the drop in the value of Sterling in mid-2016 gradually dissipate. The impact of rising oil prices may also ease in coming months thanks to a weaker market. However, it is budding domestic inflationary pressures that are causing the MPC concern.
The labour market continues to be tight, with the unemployment rate at a record low of 4.3%. The MPC now judges the equilibrium level of unemployment to be around 4.25% due to higher efficiencies in job market search and a fall in the rate of job destruction. As the actual unemployment rate is expected to dip below this threshold – the MPC fears a return of domestic wage pressures.
This has not yet translated to sharp rises in average wages. The latest year-on-year increase in regular pay in November was 2.4%, which is only slightly above the October reading of 2.3%. But surveys point at increasing pressure, with pay rises for workers switching jobs returning to a rate last seen before the Great Recession.
A strong outlook for global growth in 2018 is now expected to be met with a slightly stronger short-term outlook for the UK economy. However, the capacity to meet an increase in demand may be limited. A number of demographic trends are expected to see the supply of labour grow much more slowly than over the past decade. Unless UK productivity performance experiences an imminent turnaround, sustainable GDP growth rate may be as low as 1.5% for a while, leaving very little room for the economy to expand above that rate before overheating commences.
The risks associated with Brexit will continue to be at the back of policymakers’ minds, but may have less immediate impact on monetary policy decisions. The MPC may also be keen to prepare some policy space before Article 50 deadline, so it has more room to respond to the worst-case scenarios should they materialise.
The unprecedented period of low interest rates may have also led to a build-up of other risks in the economy which will need to be considered. Low rates encouraged investors to increase risk exposure in search for higher returns, fuelling record valuations for equities and other assets. The start of a tightening cycle may see some portfolio rebalancing towards safer assets and herald greater market volatility. We have already seen some of that over the past week.
While macro-prudential measures taken after the crisis have prevented the build-up of runaway levels of private debt – there have been some areas for concern – particularly the growth in consumer credit. Despite moderating slightly from a peak of 10.9% year-on-year growth in November 2016, latest figures show that consumer credit grew by 9.5% in December 2017. Increases in the policy rate are unlikely to have much effect on this form of credit, however rising mortgage costs may take a bite out of households’ remaining disposable income. In turn, this would both hurt their ability to take on more debt and service the interest cost of outstanding debt.
So far, the start of 2018 has not gone “off script”, however the high volatility in the markets could signal a more turbulent year. As the Brexit deadline looms at the start of next year, the Bank of England will need to carefully navigate the course of policy to balance emerging risks against the needs of the real economy and still get to 2019 with plenty of space to meet the challenges facing the UK economy.