Last year saw a sharp turnaround in the performance of the UK economy. Real GDP averaged 1.9% growth in 2013, well up on the meagre 0.3% registered in 2012.
Not surprisingly, given the increased activity levels in the economy, the labour market also experienced robust improvement. There were strong increases in employment levels, helping to push unemployment down to 7.1%, having begun the year at 7.8%.
The pick-up in activity is all the more remarkable, given the preoccupation in the early part of last year on concerns over the possibility of a triple-dip recession in the UK economy.
Notwithstanding the pick-up in the UK economy over the last year, when Mark Carney began his term as governor of the Bank of England in July 2013, the positive macro signs in the UK economy were still at a tentative stage. At the same time, there were concerns that the upward moves in market rates “risked hampering the emerging recovery”.
In response, the Bank of England moved into the realm of forward guidance in its August quarterly inflation report.
The guidance stated that the committee did not intend to raise the bank rate from its current low level of 0.5% at least until the unemployment rate had fallen to a threshold of 7%. The hope of the Bank of England was that this guidance would help keep market interest rates low.
Since then, as outlined, the UK economy has experienced a marked improvement, while the inflationary environment has become more benign. More specifically, the unemployment rate has fallen very close to the 7% threshold.
So, the Bank of England has been forced to update its forward guidance to take account of the much-improved economy, where the unemployment rate has “fallen much faster than anticipated”. This update came in last week’s February quarterly inflation report.
The ‘new phase’ of forward guidance removes the explicit link to the unemployment rate. It is now less explicit, focusing on broader conditions in the labour market and economy more generally, and shifting the focus to the concept of spare capacity in the economy.
The guidance outlines that the bank is looking for the spare capacity in the economy to be “absorbed” over the next two to three years. It is also of the view that there is scope to absorb this spare capacity further before raising interest rates.
The bank also outlined that rates are “expected to rise only gradually” and any increases in rates are likely to be “limited”.
Based on the various macro forecasts contained in the inflation report, it appears the bank is expecting to potentially start hiking interest rates in the second half of next year, although the market continues to believe that it will be somewhat earlier than this.
Aside from the change to forward guidance, the other standout feature from last week’s publication was the strong upward revisions to the bank’s economic growth forecasts. It is now expecting growth of 3.4% this year, compared to the previous forecast of 2.8%.
The revised growth forecasts combined with the watering down of the forward guidance on keeping rates low, has resulted in increased expectations that the Bank of England would be the first of the main central banks to tighten policy. This in turn provided a boost to sterling last week, which gained just over 2% on the dollar and around 1.5% versus the euro.
In terms of the interest rate outlook, market pricing continues to suggest that the first rate hike is not expected till the first half of 2015. So, while the Bank of England may indeed be the first of the main central banks to hike rates, this is not likely to happen till next year.