Weak UK inflation casts doubt on interest rate hike this year

June 17, 2014

 

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Bank of England Governor Mark Carney shocked markets last week, saying interest rates could rise sooner than expected.

At first glance, the latest UK inflation data suggest they might not.

Inflation has nearly halved to 1.5 percent in May from 2.9 percent last June. And wage inflation is much lower.

While still well above the euro zone, where inflation has tumbled to 0.5 percent, keeping alive the real risk of deflation, the latest UK inflation rate fell below even the lowest forecast in a Reuters poll.

And inflation is now 0.2 percentage point below where the BOE thought it would be in its own forecasts made one month ago.

So by all accounts, inflation is running behind where it should be to justify what was interpreted — and spun by Carney — as a very dovish set of BOE forecasts in May.

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This might explain, despite a brief rally in sterling to above $1.70, why only a handful of economists brought forward their prediction for the first rate hike after Carney’s Mansion House speech last week.

Most forecasters still say early or mid-2015, and only about a quarter of them expect a rate hike by the end of this year, despite it being fully priced into interest rate futures.

Indeed, those who are calling for an early rise don’t appear to put much weight on the path for inflation.

Of the 10 banks polled by Reuters who are predicting a rate hike this year, only one, Societe Generale, has a relatively high forecast for inflation by end-2015.

They expect it to average above target toward the end of this year and rise just above 3 percent by the end of next year.

The rest forecast inflation to average between 1.9 to 2.2 percent late next year, or in other words, very close to target.

All of this makes Carney’s sudden hawkish turn more difficult to understand, especially given that he has made clear that it is up to the Financial Policy Committee, which meets on Tuesday, and not interest rates, that should be used to tame the soaring British housing market.

Even MPC member David Miles, a known dove, is sounding more inclined to vote for an interest rate rise, according to an interview with the Times.

Malcolm Barr at JP Morgan noted:

The net result of this is likely to be to diminish the role of the Inflation Report as a means to gauge the MPC’s thinking, and to suggest that much of the analysis provided therein is simply furniture to justify a policy narrative which can change abruptly.

George Buckley, chief UK economist at Deutsche Bank, who changed his forecast for a rate hike to November based on Carney’s speech said of the May inflation data:

Given speedy pass-through from factory gate to consumer prices this suggests even our low forecasts for inflation could prove too high. For some on the MPC this may buy time before the first hike.

Jonathan Ashworth at Morgan Stanley wrote:

We expect inflation to stay below target for another 18+ months and think the MPC will give the recovery more time to build resilience, and pay growth more chance to pick up, before raising rates. We still expect the first rate rise in 1Q 2015, although after Governor Carney’s speech last week, the risk of a move later this year looks higher than we previously thought.

Even Michael Saunders at Citi, who has the most aggressive outlook for UK rate hikes, wrote:

The near-term inflation backdrop is benign, but the MPC have a well-established habit of steering by growth and capacity use – rather than the latest inflation data — as a guide to inflation prospects. We continue to expect the first rate hike in Q4 this year.

To be sure, one set of inflation data is not enough to completely change the outlook.

Wage inflation will be key, and Carney has made this clear.

Growth has been much stronger and unemployment has fallen much faster than either we or anyone else expected at last year’s Mansion House dinner. So far this has been largely matched by indicators which suggest that there is more supply capacity in the labour market than we had previously thought.

As a result of these two welcome developments, despite rapid jobs growth, pay pressures and unit labour cost growth have remained subdued.

The MPC expects the rate at which slack is being eroded to slow during the second half of this year as output growth eases and productivity growth recovers. But thus far there are few signs of a deceleration in output growth. And a challenge in deciding when to begin normalising policy is that actual output can be observed but potential supply cannot. That is why the MPC is monitoring a broad range of indicators including coincident ones such as the behaviour of wages and prices.

Average earnings including bonuses rose 0.7 percent in April, well below the consensus for 1.2 percent, and less than half the inflation rate. And pay growth is expected to average just 2 percent by the end of this year, according to the latest Reuters monthly poll.

That suggests the strong jobs recovery could carry on without pushing inflation — or rates — higher.

 

– Additional reporting by Sumanta Dey

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