The Bank of England is taking a patient approach in its deliberations in relation to the timing and extent of interest rate increases, writes John Fahy.
Last week’s meeting of the Monetary Policy Committee (MPC) concluded in line with market expectations with no change to UK monetary policy.
The MPC’s patient approach is not surprising, given the backdrop of the recent mixed performance in the global economy and a very subdued inflationary environment (currently at 0.1%) in the UK.
Even more recently has been the uncertainty in relation to Greece, as well as the market turbulence in China, where stock markets have fallen sharply.
The main focus within the MPC, and the key determinant of monetary policy, is the “prospects for inflation”.
In its assessment, the bank estimates that around three quarters of the deviation of inflation from its 2% target reflects “unusually low contributions from energy, food and other imported good prices”.
The expectation within the committee is that these factors will abate, resulting in a pick-up in inflation. The remaining ‘quarter reflects the “weak growth of domestic costs, especially wages”.
Therefore, within the context of underlying ‘inflation prospects’, the MPC will be closely analysing trends in wage growth over the coming months, while also keeping a watchful eye on any “persistent effects of sterling strength”.
In its May inflation report, the committee outlined its view that wage growth would pick up in the forthcoming quarters as labour market slack is further eroded along with a gradual recovery in productivity.
Recent data have shown that wage growth is picking up, with the weekly earnings ‘ex-bonus’ measure rising by 2.7% year-on-year in the three months to April. This represents its strongest level in six years.
However, at the same time, the MPC has noted that there is an “open question about the extent of any further wage acceleration”. On the one hand, the unemployment rate could continue to fall more quickly than expected, resulting in “increased pressure on pay rates”. On the other hand, it is possible that the “past and prospective period” of near zero inflation could dampen wage growth.
The outlook for the UK economy, in general, looks encouraging. While the economy slowed in the first quarter of this year, expectations are that it will regain momentum over the coming quarters. Leading survey indicators for the second quarter suggest that the economy grew at a solid pace.
Meanwhile, on the fiscal policy front, last week’s updated Budget indicated that there would be a smoothing of the intended fiscal tightening over the next few years.
There is expected to be a faster pace of tightening this year, but a slower pace of tightening in subsequent years, with the anticipated return to a budget surplus now pushed out by a year to 2019/20.
So, the economy still faces a headwind from fiscal tightening. Other factors which could act as a drag on growth include the high level of household debt and the negative impact on trade from a stronger sterling.
Overall though, robust consumer spending, weak inflation and an improving labour market (including an acceleration in wage growth) should provide a supportive backdrop to the economy.
In this context, the UK economy should grow by close to 2.5% this year and next year.
Recent comments and speeches from MPC members have included some more hawkish soundings in relation to interest rates. This renewed hawkishness is likely to manifest itself in some members starting to vote for a hike to interest rates at upcoming meetings.
Current market pricing suggests that markets do not expect a UK rate hike to happen until spring 2016. However, given the tightening labour market and pick-up in wage inflation, rates could be hiked sooner. Indeed, an increase in interest rates before the end of 2015 cannot be ruled out if labour market conditions, especially wage growth, continue to improve.
John Fahey is a senior economist at AIB.
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