UK Inflation Report implies no rate hike this year
Mon, Feb 15 2010, 12:41 GMT
by Trevor Williams
The Bank of England’s projections in the February 2010 Quarterly Inflation Report (QIR) for economic growth (GDP) and for consumer price inflation (CPI) are lower than those made in November last year. This has resulted in financial market expectations of rate rises being pushed out further into the second half of this year. But, as the charts below show, there is still an expectation - derived from overnight index swap (OIS) rates - that Bank Rate will rise to 1% by the end of 2010, to 1¾% in June 2011 and to 2½% at the end of next year. That view is not borne out by the implied path of consumer price inflation in the Bank of England’s latest QIR forecasts, whether based on market implied interest rates or unchanged rates at 0.5%, see charts a and b. In the Report, the Bank says that: ‘On balance, the Committee judges that….. it is more likely than not that inflation will be below the target for much of the forecast period…’ The implication is clear, there is a strong probability that Bank Rate may remain at the current record low of 0.5% well into 2011 unless economic conditions improve more than currently expected by the Monetary Policy Committee (MPC).
Reasons for the Bank of England to lower its growth forecasts are not hard to find. The UK economy expanded by just 0.1% in Q4. This means that there is more spare capacity in the economy and so medium-term inflationary pressure is even more muted than previously expected. Prospects for growth in the first half of this year look very challenging, with the reimposition of VAT at 17½%, the end of the car scrappage scheme and higher taxes from April.
World growth is recovering and that helps UK growth prospects, but the evidence so far is that the trade balance is not improving as much as is required to impart the positive net contribution to the economy that would deliver the Bank of England QIR projection of 3% annual GDP growth by the end of the year, see chart c. Part of the reason for that could be that the fast growing countries are those in which the UK has a low market share of imports, and that UK firms are not cutting export prices in order to gain market share; rather, they are maintaining them (i.e. raising export prices) in order to boost profit margins.
The view from the latest Consensus Forecast publication (for February) is that the UK will grow by 1.4% this year and by 2.2% in 2011. Of course, the QIR forecast could turn out to be correct, but that would still mean that inflation undershoots the 2% target in 2 years’ time on official projections, see chart b.
Although inflation is expected to undershoot the 2% target in the medium term, however, the Committee expects the annual rate to rise over 3% first (the annual rate was 2.9% in December 2009). Our forecast is that this will happen as soon as this month, with January annual CPI inflation hitting 3.5% and triggering a public letter by the Governor explaining to the Chancellor why it has happened, what he is doing about it and when it will be back to the target. In that letter, the Governor is likely to say that the rise was due to one-off effects associated with the 2½% rise in VAT and petrol prices, and that it will be well below 2% within the target period of 2 years.
In the QIR, the Bank states that: ‘The pick up in inflation is largely the impact of one-off adjustments to the level of prices which should have only a temporary effect on inflation. Downward pressure from the persistent margin of spare capacity is likely to cause inflation to fall back below the target for a period as these temporary effects wane….it is more likely than not that inflation will be below the target for much of the forecast period, but the risks are broadly balanced by the end.’ Our forecasts of the monthly path of annual UK consumer price inflation over the period to the end of 2011 show that it will fall well below 2%, hovering around 1% for much of 2011.
If our forecast turns out to be accurate, the key short term UK policy interest rate could stay low for an extended period, and much lower than is currently being priced into financial market expectations. This will be especially likely if UK economic growth disappoints, as it has so far in the recession. Bank of England forecasts of UK growth in 2010 and 2011 are higher than the average of independent forecasters. If the latter are right, and the MPC acknowledges this by lowering its inflation projections even further below 2%, then UK Bank Rate could remain at 0.5% well into 2011.
From a financial market perspective, this implies plenty of scope for market volatility, and perhaps opportunity as a result, in the months ahead. As mentioned in our last Weekly, much of the future prospects for the UK depend on how firms adjust away from slower growing traditional export markets into stronger growing emerging markets, helped by a cheaper currency.
