The Bank of England Preview: Trapped in inflation vs. growth dilemma

The Bank of England is set to hold it monetary policy steady in December as it is about to announce the result of the Monetary Policy Committee (MPC) meeting on Thursday noon.

While Brexit uncertainty dissipating in recent days somewhat, the Bank of England will be more focused on economic fundamentals where it is stuck with inflation vs. growth dilemma. After delivering an extremely dovish message in November rate hike, it is unlikely for the Bank to see the economic reality different from what it has been at the beginning of November even with politicians declaring the Brexit negotiations breakthrough.

With inflation above the target the Bank of England should act and hike the rates, or at least signal future monetary tightening, but with the growth below potential and possibly decelerating, any tightening would be counterproductive.  

Brexit uncertainty

Brexit uncertainty is a sure shot in every comment from the Bank of England since last year’s referendum and December meeting is no exception.

It is likely that the Bank of England will be commenting on the latest round of Brexit negotiations that have reached the first substantial move forward last Friday. Although it is still unclear what kind of deal the UK is getting in talks with EU, major hurdles with the amount of the Brexit bill to be paid to EU and the UK securing the rights of EU citizens and refraining from the hard border with Ireland have been agreed upon.

While moving forward with Brexit negotiation is a political victory for the UK government, ongoing doubts of some EU officials about the ability of the UK to agree upon trade until Brexit materializes on March 2019 still might make members of MPC uncomfortable.

What the is the Bank of England looking at?

The Bank of England has a primary target of keeping price stability in the UK in check. That is not the reality so far with the UK inflation in November breaching the upper tolerance band of 1% above the 2% inflation target.

With the UK inflation rising to 3.1% over the year in November, the Bank of England Governor Mark Carney will have to write an explanatory letter to Philip Hammond, the UK Chancellor of Exchequer. While governor Carney might seek means to explain inflation overshoot, the rest of the MPC is likely to be looking at the core inflation that is adjusting the inflation basket for food and energy items and that has remained steady at 2.7% in November.

With Brexit related Sterling depreciation being almost entirely fed-in inflation already, the inflation in the UK is set to stabilize over the short-term horizon with about 2% inflation rate in 6-9 months horizon. Such inflation stability would have enabled the Bank of England to act, especially should the economic growth prove resilient and the UK labor market remaining tight with the multi-decade low unemployment rate and rising wages.

So far, rising inflation rate is a growth negative story. With inflation rising 3.1% and wages growth rate of 2.2%, the real, inflation-adjusted income is negative weighing on consumer spending and household consumption.

While the Bank of England stressed that the UK economy is now running above its potential output driven purely by labor market factors with productivity gains well below long-term average, any reversal in the labor market shape will be seen as an important delay factor in any rate rake hike thinking. Beware of November labor market report due on Wednesday, a day before the MPC meets.

MPC voting decomposition

In terms of voting decomposition, there are only two arch-hawks within MPC, Ian McCafferty and David Saunders that have a consistent monetary tightening voting pattern. The rest of the MPC joined only for November decision as it has become increasingly clear that the Fed is on the way to deliver its third rate hike this year and the Bank of England Governor Carney made sure during the press conference that the rate hike was just a removal of extraordinary stimulus the Bank introduced after Brexit referendum last year.

So while the Bank of England has increased the Bank rate for the first time in a decade in November, only seven out of nine MPC members agreed. Deputy governors Jon Cunliffe and sir David Ramsden dissented and are likely to stick to their view also in December.  

Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these securities. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Forex involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility.