Speculation that UK interest rates might rise this year has intensified as inflation and wage growth picked up and the Bank of England governor admitted that there are limits to how great an inflation overshoot will be tolerated. But we do not agree. We see rates on hold until at least the end of 2018.
In normal circumstances, the current combination of strong GDP growth, a tight labour market, robust borrowing, a low savings rate and rising inflation would make a strong case for a UK rate rise.
Two US rate rises - with two more expected in 2017 - boosts the hawkish argument. UK interest rates tended to follow the US and the market implied probability of UK rate rise has increased to 40 per cent – which is higher than the implied probability in early 2016 of the UK voting for Brexit last June.
But times are far from normal.
Why do we continue to see rates on hold? Well, in 2011 when inflation rose above 5 per cent and the Bank of England was gearing up for a second round of quantitative easing, it did not raise rates. Nor in 2014/15, when growth was strong and the labour market tight with inflation - low because of oil prices – forecast to rise above its 2 per cent target again. Then in August 2016, the Bank launched further QE and forecast inflation rising even further above target, but cut rates.
True, this isn’t 2011. Back then, the inflation overshoot was boosted by oil prices and a VAT rise. And in 2011 the Bank was forecasting inflation to drop below target within 18 to 21 months; today it sees it staying above target throughout its three-year forecast period.
But perhaps the structural story has changed since 2011, with global investors starting to believe in a world of higher potential growth and natural interest rates – partly fuelled by Donald Trump’s presidency and expectations of a much looser fiscal policy in the US. However, we are not convinced this will lift growth beyond the near-term in the US, and much less so in the UK.
A further point is that currency weakness is part of the UK plan. Exporters will not thank the Bank for driving the pound higher just as sterling was starting to do its job.
So in a year full of uncertainty, even if our forecasts prove overly pessimistic, raising rates will still be seen as risky. We thus think the Bank will look through higher CPI inflation – our forecasts see it rising to 3.7 per cent before falling again - passing it off as imported, rather than domestically generated. We thus see rates staying on hold until the end of 2018 at least.
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The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Elizabeth Martins
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