What does the Bank of England holding interest rates mean for personal investors
The Bank of England delays increasing interest rates as UK economy weakens
The Bank of England today, as expected, held rates at 0.5%. Having indicated in February following the last Inflation Report that interest rates may rise more quickly than expected, markets had originally anticipated a rise in May. This expectation was buoyed by the Monetary Policy Committee (MPC) being split in its last meeting with two members voting for a rate increase. However, economic data since then has appeared weaker than expected and the Governor of the Bank of England had already made statements suggesting that this weakness would prevent a May rate rise and so it has proven.
There are a number of interesting comments in the release and Inflation Report today. Notably, that surveys are indicating Q1 GDP growth may have been stronger than the initial estimate (of 0.1%) suggested. The Bank indicates that its central forecast for economic activity is ‘little changed’ since its last report. This perhaps implies that it is not the economic growth data that has led to the Bank to not increase rates this time around. Rather the cause is in the comments relating to inflation – namely that the impact on inflation of Sterling’s devaluation is dissipating more rapidly than expected, meaning that inflation is expected to come back to target within two years. This does assume a steadily rising path of interest rates but implies that interest rates may not have to rise as fast or as much as perhaps was previously expected. Overall the MPC continues to see excess demand building in the economy and notes the building pressures for higher wage inflation as unemployment remains at low levels and employment remains strong.
So when is it likely that interest rates will rise?
If the Bank is correct and Q1 GDP estimates are revised upwards and wage growth continues to accelerate such that real wage growth returns then the Bank will in our view undoubtedly raise interest rates at the time of the next Inflation Report in August if not before.
Two members of the MPC voted for a rate rise this time. The Bank acknowledges that if the economy performs as expected, and its central forecast is relatively unchanged from February to May even with the recent relatively weak data, then interest rates need to rise on a gentle path over the next three years. Assuming economic data continues in line with, or better than expected, there will be little reason why rates would not then be increased in August at the latest.
Are Geo-political tensions really impacting the decision?
Political events always have the ability to impact economic decision making and there are two aspects here worthy of note. First are the Brexit discussions. As the UK heads through the summer these negotiations should be starting to draw to some conclusions. If that is not the case, and instead they become rocky or drive increased political instability within the UK given the Government’s relatively precarious parliamentary arithmetic, this could have a damaging effect on short term consumer confidence and business investment. Evidence of such impacts could cause the Bank of England to delay a rate rise further. The second event is the increase in Middle East tension which is at least in part responsible for the rise in the Oil price. This has increased from c.$45 last June to now approaching $80. That scale of increase has many impacts not least on inflation through higher petrol prices and may cause the decline in inflation to stall potentially encouraging the Bank to act unless they choose to ignore this as another temporary phenomenon.
How have personal investors reacted to today’s news?
For personal investors the immediate market reaction was to see a small (c.0.5%) jump in the FTSE100 index and a fall of c.1% of Sterling against the US Dollar – adding to recent weakness which has seen the Pound fall from highs of just over $1.43 to now around $1.35, a fall of over 5%. This will have a very modest inflationary impact, prolonging the impact of Sterling’s devaluation on inflation contrary to the Bank of England’s short term observations, and should help further boost the export of goods and services as well as increasing the Sterling value of companies’ overseas earnings.
For savers today’s news will be a disappointment as returns on cash savings remain paltry, and as interest rates remain substantially below inflation holding cash actually costs savers in terms of purchasing power. Part of the economic challenge as shown in the data commented on by the MPC is the decline in consumption. For those trying to drive an income from their savings or investments negative real interest rates and a further hold in rates this month does nothing to help drive consumption higher.
What’s on the horizon for the rest of 2018?
We continue to believe that the economy will perform better than expected through 2018 unless there is a collapse in the Brexit negotiation process. The weak Q1 data, which the MPC indicates may be revised upwards, was largely due to the prolonged and bad winter weather which particularly hit the construction sector. Wage inflation is undoubted increasing as pressures build in the labour market and there will likely be more wage related industrial relations disputes as we head through the summer. All of this points to ultimately higher inflation unless action is taken to dampen some of the excess demand building in the economy. We believe rates should be increased and would expect the MPC to do so by 0.25% in August if not before. This will be significant as it will be the rise which takes rates above the level to which they were cut in 2009 as a result of the financial crisis.
We believe it is possible that increasing rates may serve to increase consumption as those with savings – particularly those who are retired – see incomes increase. Higher borrowing rates may lead to increases in corporate failures which restrict elements of supply – and we are already seeing current consumption weakness having an impact on the High Street. Combined these impacts may mean that the effectiveness of increasing interest rates on bringing down inflation may not be as strong as was historically the case in previous cycles when rates rose. Consequently interest rates may, over the three year horizon, actually need to rise further than is currently anticipated.
There is much, economically and politically, that can happen over even a short time horizon. For now markets will appear relieved that the MPC has held off a rise for this month. However, we expect economic data to perform in line with the MPC’s central projection over the coming months and therefore would see a rise in August when the next inflation report is produced, if not before, as inevitable, needed in the face of growing inflationary pressures, and undoubtedly welcome for those with cash savings who have seen the value of those cash savings fall in real terms over a very prolonged period.