We have moved the first BoE hike to November 2015

• We have postponed our expectations for the first Bank Rate hike three months from August 2015 to November 2015. The main reasons behind our new call are that we have pushed our call for the first Fed hike to September, the appreciation of the GBP in recent months and slower growth in Q1 15.

• We still believe that Bank of England will hike this year despite low inflation, as inflation is expected to pick up when the effect of the drop in food and energy prices starts to fade. We expect wage growth to pick up further this year in step with the decline in labour market slack. However, future wage growth remains a downside risk to our call.

• Along with our call, we have revised our yield forecast down some 10 to 20bp across the GBP curve and our 1- to 6-month EUR/GBP forecast slightly higher.

We have moved the first BoE hike to November 2015

We have for some time argued that we consider the Bank of England (BoE) to be a ‘light version’ of the Fed. By ‘light’ we mean that we expect the BoE to hike a few months after the Fed and that BoE will likely hike more gradually. As we now expect the FOMC to wait until September, we have pushed our call for the first Bank Rate hike from August 2015 to November 2015. However, it is not only the timing of the first Fed hike that has led us to change our minds. Firstly, minutes from meetings in the BoE’s Monetary Policy Committee (MPC) held this year have been dovish. A major concern for the MPC is the appreciation of the GBP in recent months, which is likely to weigh on inflation through lower import prices. Secondly, wage growth, which is a key determinant for the MPC’s hiking decision, is still subdued despite the improvement in the labour market. Thirdly, it seems that growth slowed in Q1 as both industrial production and construction output have disappointed. As inflation is still very low, the MPC will probably want to wait and see whether or not growth picks up in the coming quarters, as a more persistent slowdown will feed into the labour market also.

As we expect the first hike in November, we think that the BoE is priced much too dovishly (first hike set for Q3 16). The first reason why we still expect a hike this year is that we expect inflation to increase in H2 15 as the effect of the drop in energy and food prices begins to fade. We forecast that inflation will increase to 1.7% at the end of next year, which is not far from the BoE’s 2%-target. Hence the medium-term inflation outlook, in our view, still calls for a hike. The second reason is that we expect growth to pick up in the coming quarters, supported by a combination of increasing growth in the euro area and positive real wage growth for the first time since 2009. As we expect the unemployment rate to reach the BoE’s estimated medium-term equilibrium rate this year, we also believe that wage growth will pick up sooner or later. However, future wage growth remains a downside risk to our call. As guided by the MPC, the Bank Rate will be increased only gradually and slowly in a new hiking cycle.

Softer MPC concerned about the appreciation of the GBP

The MPC has become more dovish in 2015. The minutes from the January meeting revealed that the two hawks, Ian McCafferty and Martin Weale, who previously voted in favour of increasing the Bank Rate by 25bp at several meetings, are now in favour of keeping the Bank Rate unchanged. One reason for the softer MPC is due to the appreciation of the GBP, see also UK: The appreciation of sterling worries the MPC, 18 March 2015, which is likely to weigh on inflation through lower import prices. From November 2014 to mid-March the effective exchange rate (trade-weighted GBP) appreciated 5.6%, mainly explained by the drop in EUR/GBP as a result of the ECB’s decision to launch a QE-programme (EUR accounts for 47.3% of the effective exchange rate). Although the GBP has depreciated somewhat due to a combination of the softer MPC and weaker economic data, the effective GBP is still 2.5% stronger than in November 2014 – and 12.7% stronger compared to March 2013. It is important to remember that a stronger GBP affects the UK economy more than a stronger USD affects the US economy since the UK economy is more open. While imports and exports account for 16.4% and 13.2%, respectively, of GDP in the US, they account for 29.8% and 28.4% of GDP in the UK, respectively. This implies that movements in the GBP have a larger impact on the UK economy both with respect to economic growth and inflation.

Kristin Forbes, who is an external member of the MPC, explained the effects of movements in the GBP in more detail in a speech from October 2014, see The economic impact of sterling’s recent moves: more than a midsummer night’s dream. According to Forbes, movements in the GBP affect inflation more than they affect economic activity through foreign trade. Based on model simulations, the BoE finds that growth in the UK export markets is much more important for UK exports than movements in the GBP. As we are quite optimistic on the growth outlook in Europe, we are also optimistic with respect to the export outlook in the UK. Looking at the effects on prices, large movements in the GBP (i.e. +/- 5%) have a pass-through of 90% on import prices with most of the effects within 6-12 months. As the import intensity in the CPI index is around 30%, the overall pass-through to CPI inflation is 27%. This means that a 10% appreciation of GBP over time will reduce the consumer price index by 2.7pp. The BoE estimates that less than half of this adjustment will occur over the first year – most by the end of the third year. The further appreciation of the GBP since the end of last year implies that there is fundamental downward pressure on inflation through lower import prices.

Subdued wage growth and slower economic growth in Q1

Although the BoE is targeting inflation, the MPC follows the developments in the labour market closely. In the latest Inflation Report, the BoE estimated that the slack in the labour market is around 0.5% of GDP. The unemployment rate has been declining since the end of 2011 and was 5.7% in February - not far from the BoE’s estimated mediumterm equilibrium rate of 5.5%. The slack has declined in step with the economic recovery. We expect the UK to continue to recover in the coming years, mainly driven by domestic demand. In Q1 15 PMI services pointed towards growth in gross value added for the service industries of around 0.75%-1.00% q/q. However, ‘hard data’ for production and construction have disappointed in Q1 indicating that GDP growth has slowed down in Q1 compared to Q4 14. We expect growth to rebound in the coming quarters but the MPC will likely wait and see whether or not the slowdown persists as slower growth could spill over to the labour market.

Despite the falling unemployment rate, nominal wage growth has been subdued. Average weekly earnings ex bonus are low both from a historical perspective and compared to the actual unemployment rate. Future nominal wage growth is a key determinant for the timing of the MPC’s hiking decision, as higher wage growth is crucial in order for the BoE to reach the inflation target. As we expect the improvement in the labour market to continue, we also expect wage growth to pick up further later this year. However, continued subdued wage growth remains a downside risk to our new hike call.