Spotlight on UK rate hike as recovery picks up

Last week’s preliminary estimate of UK second-quarter GDP showed that the economy continued to maintain its strong momentum.

The economy registered quarterly growth of 0.8%, matching its pace from the first quarter. On a year on year basis, the rate of growth picked up to 3.1% from 3%.

While the expenditure breakdown of the latest GDP data is not yet available, retail sales data over the period indicate that consumer spending remained an important driver of growth.

In the second quarter, sales increased by 1.6% quarter on quarter, representing an acceleration in the pace of growth, compared to the 0.7% increase in the first quarter.

The economy added 254,000 new jobs in the three months to May. Compared to the same period a year earlier, this translated into a 3.1% growth rate, a 25-year high.

These healthy gains in employment have helped to push the unemployment rate lower. The jobless rate stood at 6.5% in May, a five-and-a-half year low, and down from a rate of 7.8% a year ago.

Overall, the broadening base of the recovery, continued strong levels in leading indicators, improving labour market trends, as well as an expected pick-up in growth in its key trading partners, all suggest that the UK recovery will prove sustained.

The economy still faces considerable headwinds, including household deleveraging, restrictive credit conditions, fiscal tightening, as well as sluggish income growth and sterling’s appreciation over the past year. However, GDP growth is likely to average 3.25% in 2014 and 3% in 2015.

The strong performance has had an impact on the Bank of England’s Monetary Policy Committee policy deliberations. Back in the summer of 2013, the UK recovery was still sluggish and the bank was warning that the increase in market rates was ‘unwarranted’.

It then spent much of the following 12 months trying to dampen down market speculation about possible rises in UK interest rates, notably through its forward guidance that rates could remain low.

However, as the economy has continued to pick up, the committee has been forced into a rethink over the potential timing of rate hikes and a more hawkish tone has started to emerge.

In recent months, the bank has gone from warning rate hike speculation was unwarranted to noting that the first hike in UK interest rates could “happen sooner than markets expect”.

The decision on the timing of a rate hike, in the words of governor Mark Carney “will be data driven”. The data will be assessed in the context of the spare capacity in the economy, which is the key tenet of the bank’s current form of forward guidance on interest rates.

A complicating factor for the committee is the conflicting signals over the degree of slack in the labour market. The economy has recorded very strong job growth, however, wage inflation remains very weak. Average weekly earnings rose by a meagre 0.3%, on a year-on-year basis, in the three months to May. With inflation currently at 1.9%, real wage growth is still in negative territory.

The minutes from the July policy meeting show that the committee still retains its unanimity with no members dissenting and voting for a rate hike. However, the text of the minutes from their last three meetings shows for some members, the monetary policy decision “had become more balanced” than earlier in the year.

How soon the developing ‘hawkishness’ within the committee translates into an actual rate hike will depend on how the economy evolves over the coming months. If the economy maintains its upward trajectory then the bank may begin hiking later this year or in early 2015.


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