IHS Global Insight Perspective | |
Significance | The Bank of England's decision to leave interest rates unchanged at 0.50% was always odds-on, but it is highly likely that there was a lively debate within the Monetary Policy Committee (MPC), reflecting the major uncertainties and risks currently surrounding both the growth and inflation outlooks. |
Implications | The MPC is having to tread a very fine line at the moment and it undoubtedly discussed the cases for both tightening and relaxing monetary policy as well as leaving it unchanged. |
Outlook | On balance, IHS Global Insight thinks it more likely than not that the Bank of England will keep interest rates down at 0.50% during the rest of 2010 and throughout the early months of 2011, given likely bumpy and overall muted recovery. We expect the first interest-rate rise to 0.75% to come around mid-2011 and see rates still as low as 1.50% at the end of next year. |
The Bank of England has kept interest rates unchanged at a record low of 0.50% and again announced no extension to its quantitative easing (QE) programme at the conclusion of the 4–5 August meeting of its Monetary Policy Committee (MPC). The Bank of England launched its QE programme in March 2009 and spent a total of £200 billion (US$318 billion) through to February 2010, mainly buying government bonds (gilts). Meanwhile, the Bank of England has now kept its key interest rate at 0.50% for 18 months, having cut it by a cumulative 450 basis points from 5.00% between October 2008 and March 2009. This is the lowest interest rate since the Bank of England was founded in 1694.
Split Vote Likely
With growth and inflation risks both finely balanced, it was always the most likely option that the MPC would keep interest rates unchanged at 0.50% and the stock of QE at £200 billion. However, this decision is likely to have followed an intense debate within the MPC that also covered the cases for both tightening and relaxing monetary policy. There was almost certainly a split vote, with Andrew Sentance likely to have remained in favour of a 25-basis-point interest-rate rise to 0.75%. Although IHS Global Insight doubts that anyone will have joined Sentance in voting for an interest-rate rise, it is not inconceivable that he was no longer a lone voice calling for a small rate increase, as he had been at both the June and July MPC meetings. It is equally not inconceivable that at least one MPC member voted for a resumption of QE. Certainly, the minutes of the meeting and the voting behaviour will make for interesting reading, but we expect that there was an 8-1 vote for unchanged interest rates and a 9-0 vote for keeping the stock of QE at £200 billion.
Growth and Inflation Risks Finely Balanced
Surprisingly strong GDP growth of 1.1% quarter-on-quarter (q/q) in the second quarter does not mask the fact that the U.K. recovery is still limited and faces serious headwinds. Indeed, fears over the strength and sustainability of the recovery have been fanned by recent survey evidence showing service-sector activity slowing to a 13-month low in July, consumer confidence weakening appreciably to a 12-month low, and manufacturing export orders stalling. It is clear that the extra fiscal tightening announced by the government has already had a significant dampening influence on the confidence of consumers and businesses, and this increases the risk that it will adversely affect their behaviour even before the main fiscal tightening measures are enacted and really start to bite. Meanwhile, persistently tight credit conditions, slowing global growth, and still significant problems in the Eurozone pose significant downside risks to U.K. growth.
On the other side of the coin, consumer price inflation is coming down agonisingly slowly from well above-target levels and was still up at 3.2% in June. At least though, this is down from the peak of 3.7% in April and there are some signs that underlying inflationary pressures are easing. In particular, the prices-charged indices of both the services and manufacturing purchasing managers' surveys fell back in July, as did the input price indices. In addition, it is worth noting that consumer price inflation excluding indirect taxes stood at 1.6% in June, down from a peak of 3.0% last November, while consumer price inflation at constant tax rates was down to 1.5% in June from 2.9% last November.
Although it is apparent that none of the MPC members is happy with recent inflation levels, it is also apparent that they still see downside as well as upside risks to the long-term inflation outlook. On the upside is the risk that with consumer price inflation likely to remain above its 2.0% target level throughout much of 2011 because of next January's value-added tax (VAT) rise (from 17.5% to 20%), inflation expectations could become entrenched at a higher level, thereby affecting consumers' wage demands and businesses' pricing policy and making it harder to bring consumer price inflation back down to 2.0%. On the downside, the MPC sees a risk that money spending in the United Kingdom will remain weak, with the economy operating below capacity and keeping consumer price inflation under its 2.0% target level over the medium term.
In fact, there continues to be major uncertainties within the MPC over how much spare capacity there is in the economy and how much this will hold down inflation over the longer term. The central view still seems to be that there is enough spare capacity to bring consumer price inflation back down to the 2.0% target level over the medium term.
Adding to the inflation debate, sterling has been firmer recently, which reinforces belief that the upward pressure on inflation coming from past sterling weakness should increasingly wane. However, there is growing concern that food prices will be pushed up over the coming months by higher wheat and other crop prices.
Outlook and Implications
On balance, we think it more likely than not that the Bank of England will keep interest rates down at 0.50% throughout the rest of 2010 and the early months of 2011, given likely ongoing bumpy and overall muted recovery in the face of significant headwinds, most notably the fiscal squeeze that will increasingly start to bite, problems in the Eurozone, and slower global growth. We expect the first rise to 0.75% to come around mid-2011. One thing that does seem clear is that interest rates are likely to remain very low for a considerable time to come, regardless of when they first start to rise. Monetary policy will need to remain loose for an extended period to offset the impact of the major, sustained fiscal squeeze.
Meanwhile, there remains a very real possibility that the Bank of England could revive QE should the economy falter appreciably over the coming months as the Bank of England is clearly concerned about still tight credit conditions.
Important insights as to how the Bank of England sees monetary policy developing should come with next Wednesday's (11 August) release of the August Quarterly Inflation Report, which will include its new GDP growth and inflation projections. The Bank of England is likely to have had the unpleasant task of lowering its GDP growth forecasts but raising its consumer price inflation projections.