November 16, 2017
No, I refer not to the oft quoted (in)famous Chinese curse, but instead to recent events in Threadneedle Street.
In the spirit of a WW1 offensive, we had been ‘softened up’ for several months now in the speeches which key individuals at the BofE have been delivering since the start of the year. What made me think that there might actually be something in this was Andy Haldane, in particular, making hawkish noises about a rate rise in Spring/Summer this year.
But still – a rise from the ’emergency’ rate of 0.25% to 0.5% does pose the question: What does it all mean?
Before we get onto this – or, rather, some thoughts as to what it might mean – it is interesting to note that base rates have DOUBLED (if you are a tabloid headline writer). Lies, damned lies and statistics anyone….?
As to what this all means, well that is possibly a bit more open to debate. Of course, at one level it is very clear. It means that debt which is priced in variable rates will increase in cost (but only somewhat). Everything else being equal it should lead to a strengthening of sterling; although given the market’s (whoever that is) expectations of a rate rise perhaps all of that has already been priced in.
The Bank, in very guarded language as you would expect (although arguably a little more clearly and less contradictory than some of its recent speeches / press releases) notes that their remit of setting the base rate cannot compensate for all of the macro economic effects of Brexit – in whatever form that takes. And that it had to balance off the risks to the economy of raising the rate now given the Brexit uncertainty with its commitment to targeting an inflation rate of 2%. 7 of the 9 members of the rate setting committee thought that the risks were greater in not increasing the base rate.
What seems to have been quite important in deciding to raise the rate is expressed thus in the press release accompanying the rise:
“.The steady erosion of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. Unemployment has fallen to a 42-year low and the MPC judges that the level of remaining slack is limited…”
Very simplistically we have always been told that a reduction in unemployment rates leads to the need for employers to pay higher wages not only for new workers but also for existing ones. Those increases in wages (or, rather, take home earnings) mean that more money is chasing the existing goods and services causing them to rise in price – ie society is undergoing cost inflation driven by wage inflation. And the cycle can set up a rather elegant (but ultimately painful) feedback loop.
That is what we have been told. Historically it seems to have held true. The ‘mathematics envy’ infusing modern economics means that this relationship between inflation and wages is expressed as the Phillips curve. But in the UK it doesn’t seem to be that wage rises have been driving inflation. As the bank noted in a recent speech, rather it is because we are such a profoundly open economy which trades with the rest of the world that this means that our economy is especially effective at importing a number of economic storms from elsewhere across the globe – including inflation.
CPI currently is running at around 3.0% and is forecast to increase further. This is apparently principally due to weakening sterling.
The problem for the UK is perhaps not so much the slight increase in the cost of debt driven by the base rate increase – but what the knock on effects might be for consumption spending. It seems that there are likely one of two paths (neither of which are ideal). We either maintain our levels of consumption but finance it through increasing levels of personal debt – the bubble inflates further. To this end it is worth noting that average savings rates across the UK are at their lowest since this data began to be collated in the early 1960s.
Or consumers act like rational economic men and women and consumption spending is reigned in. The problem here is that some 2/3 or so of GDP is driven by consumption spending. In an ear of weaker GDP growth what would be the impact of it reducing and falling even further behind the G7 average? Feels a bit like we are trying to chart a course between Scylla and Charybdis…
Businesses will be affected differently by the rise – a glib statement, I agree, but nonetheless true for all that.
I do tend to try and see the glass as half full when it comes to considering economic data – but an uncomfortable little thought has been growing in my mind since the rate rise. Is it that the BofE is expecting much more difficult economic conditions rushing headlong at the UK over the coming year or so (such as Brexit, more realistic medium term productivity growth assumptions and their impact upon the deficit / national debt and HMG spending plans as a for instance) and is trying to give itself some greater room for manoeuvre? In other words, it is easier to have a meaningful rate cut from 0.5% base rate levels than it is from 0.25%.
If such a view is correct then the recent rate rise should not be seen as indicating a slow, gradual return to ‘normality’ but rather something really quite different.
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