Bank of England preview: A rate hike will not finish low-interest rates era in the UK

With inflation at the upper boundary of the tolerance band and the uncertainty about the future development of British economy, members of the Monetary Policy Committee of the Bank of England will convene this Thursday. The nine-member committee favors current stimulus of ultra-low interest rates combined with the monthly bond purchase program, with no change expected by markets.

Rock hard hawks voting for interest rates hikes for several months already are represented only by two external members of the committee, Ian McCafferty and Michael Saunders. Their voting pattern in favor of interest rate hike, as well as the end of the asset purchasing program, is justified by the fact that Brexit related unprecedented drop in economic activity never really happened so far and, even more importantly, because inflation exceeds its own inflation target of 2 percent. Despite the fact that consumer inflation in Britain is currently a combination of weakening pound and the energy prices, both factors outside the scope of the monetary policy.

The key question is whether the Bank of England chief economist Andy Haldane will join the camp of hawks within monetary policy committee. He has already said back in June that there had been a shift in the break-even point between when it was “too early” and when it was “too late” to raise interest rates. Haldane said that he is convinced that a tightening of monetary policy is likely to be needed even before the current scope of market expectations.

UK CPI (YoY) at 2.9%, a temporary overshoot or something else?

Inflation measured by the consumer price index rose by 2.9 percent year-on-year in August, with motor fuel prices being the main driving factor. The effect of Sterling’s depreciation pushes the import prices higher affecting domestic price level in the UK.

Nevertheless, since February of this year, inflation has exceeded the central bank's two percent inflation target, which has already announced that in the light of Brexit-related uncertainties it is willing to tolerate an overshoot in the inflation target, assuming that inflationary factors are of a temporary nature. Post-Brexit related Sterling’s depreciation is expected to gradually fade out in 2018 and domestic prices are expected to drive UK’s inflation only.

In this context, wage growth is of the utmost importance in the UK. Wages are rising at a significantly lower pace compared to inflation. According to the latest reports from the UK labor market, average weekly earnings of employees in the UK rose 2.1 percent year-on-year in July, both including and excluding bonuses. This means that real, inflation-adjusted wages fell 0.5 percent over the year and the aggregate output of the economy is determined by growing number of employees at the labor market. This is confirmed by the unemployment rate of 4.4 percent in July, the lowest level since 1975.

Even if the Bank of England will raise interest rates over the horizon of next twelve months, it should not be interpreted as the beginning of the tightening cycle, but mere leveling of emergency post-Brexit rate cut from August last year.