With such similar inflation, how far behind the Fed can the BoE be?

November 18, 2015

RTR4OY3Z.jpgNot long ago, the big debate was over who would raise rates first, the U.S. Federal Reserve or the Bank of England. Now with the Fed giving clear signals it’s on the brink of hiking and the BoE appearing to be pushing that day further off into the future, one could naturally conclude that the inflation outlook in both economies is vastly different.

Except it’s not. If anything it looks like the UK is only a little bit behind.

Prices fell 0.1 percent in October compared with a year ago in Britain while in the U.S., they rose just 0.2 percent. Even in China, where growth is reported at just under seven percent, inflation has fallen well below 2 percent.

But while expectations for the first Fed hike in almost a decade have now clearly converged around December, the BoE is not likely to raise rates until six months later, according to Reuters polls — and even longer if interest rate futures are to be believed.


A big reason for the varying expectations no doubt is rhetoric from policymakers at the Fed and the BoE, because economic reports have pointed to roughly similar performance.

Economic growth is almost on par in both countries, employment has picked up and wages have begun showing signs of rising. The unemployment rate, at 5.0 percent in the U.S. and 5.3 percent in Britain, is almost identical.

Fed Chair Janet Yellen’s signal that a December rate rise is a “live possibility” has been supported by comments from other policymakers who have hinted the world’s largest economy is ready for higher interest rates. That latest strong hint comes after the Fed passed on an opportunity to raise in June, and then again in September.

BoE Governor Mark Carney, on the other hand, sounded dovish earlier this month when the Bank’s latest forecasts showed it didn’t expect inflation to pick up pace anytime soon.

Both central banks target inflation around 2 percent in the medium-term. The Fed, which has a dual mandate that includes full employment, looks more closely at Core PCE prices which rose 1.9 percent between April-June on a year ago.

But it still keeps an eye on headline inflation and the long-term outlook for price rises isn’t all that different either.

Consumer prices are expected to rise 2.1 percent by the end of 2016 in the U.S., not far off from the 1.6 percent consensus for the UK for the same period, according to Reuters polls.

Citi economists wrote in a note:

Policy divergence is back on the table as the main story – the likelihood of a Fed rate hike in December seems to be rising… (and) the ECB seems set to ease further.

Historically, UK rate cycles have tended to move a little more closely with the euro area than U.S., but have not been very closely linked to either. At present, we believe the UK’s rate cycle is likely to be roughly midway between the U.S. and the euro area. The next UK rate move is probably up (like the U.S.) rather than down (like the ECB), but (unlike the U.S.) probably is distant.

The ECB is widely expected to add to its massive stimulus programme next month, or cut the deposit rate, or do both, in yet another attempt to boost inflation in the currency bloc. Those measures will take euro zone monetary policy further out of line with the U.S. and Britain, its key trading partners.

If the Fed does move six months before the BoE, the pound would likely weaken further on a renewed dollar rally and drive inflationary pressures up in the UK by making imports costlier.


That might give Carney room to justify a rate hike. British house prices, too, have accelerated recently and waiting too long to end the easy monetary policy of the past half-decade could stoke a property market bubble and put the economy at risk.

Markets are pricing in a 25 basis point hike by the BoE only in early 2017. But BoE Deputy Governor Ben Broadbent on Wednesday suggested the interpretation of the Bank’s latest inflation forecast as a pledge that rates would not rise for another year was a misinterpretation.

If that is true, the Reuters consensus for a rate hike by the middle of next year may be closer to the truth.


(Krishna Eluri contributed to this post)

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