Decoding Messages From The Bank Of England

Will UK interest rates rise or fall? Those with their hands on the lever seem hard-pressed to make up their minds, and there is some confusion as to the message coming out of Threadneedle Street.

Less than a year ago we were told rates might rise toward the end of last year. Now there are even murmurs of a cut. We were told unemployment was key, now we’re told it is economic ‘slack’.

Base Rate Languishes

In March 2015 it is exactly six years since the Bank of England cut its base rate to the historic low of 0.5 percent. The world has changed. The economy has revived. The FTSE World Index has risen 187 percent. But the base rate has languished.

When current governor Mark Carney first introduced forward guidance in mid-2013, the central tenet was that rates were unlikely to rise until unemployment fell below 7 percent, a seemingly safe bet as this was not expected to happen until late 2016. In January 2014 it was 6.9 percent. In December 2014 it was 5.8 percent.

But instead of triggering an increase in rates, we seem further from a rise now than at any time since the end of the financial crisis. The likelihood of the base rate being cut is of course marginal. But it was discussed at a recent Bank press conference as a possibility in the event of continued weak wage growth and negligible inflation – a fair description of where we are now. Inflation fell to 0.3 percent in January, well below the Bank's 2 percent target.

There are two important factors currently affecting UK inflation. Global oil prices are in a slough, below $50 a barrel as of mid-March and with U.S. inventories as high as they have been in 80 years. The structure of UK retailing is altering rapidly and significantly, with once all-dominant mid-market players grappling with a fierce attack from discounters.

Inflation Expectations

The critical issue, though, is not what has happened or even what is happening now, but what do people making buying or investment decisions think will happen in the future? What in aggregate are UK inflation expectations?

Bank officials underline that the oil price and supermarket discount wars are likely to be temporary factors and their effects will diminish throughout 2015. Far from being on the brink of a spiral of deflation, the UK is likely to benefit from a short-lived, virtuous period when prices for essential goods decline. The key impact will not be to frustrate spending but to free up income, potentially increasing spending among a population whose real wages have been ground down over several years of fiscal austerity, weak growth and the inflationary effects of quantitative easing.

If spending and investment were to pick up as disposable income rose due to lower costs, it would add fuel to an economy that has been growing at pace. The fourth quarter of 2014 was the eighth straight quarter of rising UK GDP, all but one at a rate above 0.5 percent.

Vague BoE Messages Continue

You can see why the Bank might not know whether to raise or cut, and why its messaging might seem confused. It is in this context that it has moved to the idea that the key indicator for monetary policy should be economic ‘slack’. The concept of slack, or spare capacity, is somewhat vague. It is especially difficult to measure or predict in an economy as open and globalised as the UK, where net inward migration remains high.

As in other developed economies, UK headline employment figures can be especially crude. Participation in the UK has fallen and remained weak relative to historic recoveries. Those who do have work are too often under-employed. Surveys show that many workers would like better quality terms, data supported by widespread anecdotal evidence of zero-hour contracts and no-pay internships. Many would like more hours, and many work in jobs that are low-skilled relative to their qualifications.

These issues are hard to quantify. As a proxy, the Bank will focus on productivity. If productivity fails to pick up, it would indicate that the economy is less likely to grow by producing more goods and services using current levels of labour and capital. This would in turn imply that inflation was likely to rise. Improving productivity, by contrast, would imply lower inflation.

Inflation Could Rise Faster Than Expected

What will happen? There is an outside chance that inflation will rise faster than expected. If a future government were to increase fiscal austerity by raising indirect taxes and such sources of public sector income as tuition fees, this would, somewhat perversely, put upward pressure on prices.

Bond markets are pricing in a rate rise in the latter half of 2016. Whatever the timing, the lift will be gradual. The new normal for UK interest rates is likely to sit at around 3 – 4 percent, substantially below the 5 percent judged to be the appropriate average from the late 1990s to the financial crisis.

Whatever the new normal will be, economists and investors alike will be spending the months to come in a continuous effort to decode messages from the BoE.

Biola Babawale is an economist at Vanguard Europe

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