Monetary Policy & Inflation | UK
Bank of England policy was kept unchanged at the recent June meeting and the Monetary Policy Committee (MPC) kept its hawkish guidance. Dismal UK manufacturing data for April prompted only a small downgrade to growth expectations, while the MPC’s other macroeconomic views were deemed broadly in line with the May Inflation Report forecasts. These hawkish views indicated a substantial margin of excess demand and inflation developing over the medium term (Chart 1)…
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Bank of England policy was kept unchanged at the recent June meeting and the Monetary Policy Committee (MPC) kept its hawkish guidance. Dismal UK manufacturing data for April prompted only a small downgrade to growth expectations, while the MPC’s other macroeconomic views were deemed broadly in line with the May Inflation Report forecasts. These hawkish views indicated a substantial margin of excess demand and inflation developing over the medium term (Chart 1).
Chart 1: BoE’s trade-off at the 2yr horizon
Source: BoE and Heternomics
Note: each dot corresponds to a forecast combination from a different Inflation Report. The ‘Lambda cone’ indicates the plausible extremities an MPC member might have in the trade-off between spare capacity and excess inflation. North-easterly movements indicate hawkish forecast news.
Financial conditions have loosened even further since the Bank’s May forecasts and, consequently, the disparity between market pricing and the outlook that the MPC projects is only becoming more striking. A mechanical update of the BoE’s model indicates hawkish pressure, despite the softer short-term GDP news (Chart 2).
Chart 2: Mechanical impact on the BoE’s inflation forecast
Source: Heternomics
Note: illustrated impact is on the BoE’s inflation forecast conditional on unchanged policy. It uses the impulse response functions from its core model.
Brexit Risks Loom
Looser financial conditions may partly be due to markets perceiving an increased risk of a disorderly Brexit. Therefore, the hawkish pressure could be arising because of different assumptions on Brexit outcomes. The Bank must assume the government policy of leaving the EU with a deal after a smooth transition, whereas markets must also price in the risk that such an outcome doesn’t happen. Real risks can’t be assumed away, and the MPC wouldn’t try to persuade people otherwise. One might, however, legitimately question the extent to which dovish market moves are Brexit related.
UK Markets Eyeing Fed and ECB Dovishness
Another reason for the market’s dovishness, compared to the Bank’s, is that investors may be anticipating that actions of other central banks could spill over to the UK. If the global economy were slowing hard, depriving the UK of export demand and depressing data, then it would be entirely reasonable to read across from the shock’s source. That doesn’t seem to be the case, though, with the world economy looking far from a slide towards recession.
To the extent that there is a fundamental justification for the looser global monetary policy, it is that disinflation may be a secular feature in some countries. Indeed, USD and EUR inflation swaps show some signs of a downside de-anchoring of expectations. That hasn’t happened in the UK, though, and the BoE is pointedly acknowledging that difference. By extending the dovish global policy to the BoE, the UK is being forced to take monetary medicine without any of the underlying sickness, which may well cause unwanted side effects.
BoE’s Delicate Communication with Markets
If the MPC knew that the market was using an inappropriate reaction function to price its policy outlook, then it would be reasonable to strengthen guidance in the way that it had to do ahead of previous rate hikes. However, the effect of different disorderly Brexit risk assumptions cannot be disentangled from perceptions of the broader reaction function, where only the latter warrants policy warnings.
Waiting Game
While the two effects ensnare the market, there is value in waiting for some more clarity, especially as a delay to guidance would allow the MPC to see a potential rebound in manufacturing after the sector’s concentrated maintenance cycle in April. Recent comments from Saunders, Haldane and parts of the collective MPC minutes show discomfort in the excesses accumulating in the outlook. In my view, a hawkish break remains likely to occur much sooner than the market expects, conditional on a smooth withdrawal from the EU.
Timing the Politics
How the Brexit process resolves will be a matter for the next Prime Minister, and Boris Johnson has strengthened his claim for the position in recent weeks. His decision to hang back from the initial frays of the leadership contest has left him more wriggle room in negotiations than might otherwise have been the case. The intention to leave at the end of October, with or without a deal, is the riskiest position so far and means that the reality of Johnson as Prime Minister would concentrate more of the no deal risk onto the end of October.
Resolving the Brexit uncertainty sooner would aid the BoE in identifying market assumptions about the reaction function, though, and ultimately help it raise the hawkish alarm again. Now probably isn’t the time for markets to price a more hawkish tilt but, with more clarity on Brexit outcomes, the BoE’s hawkish reaction function can shine through again.
Phil Rush is the Founder and Chief Economist at Heteronomics, an independent macroeconomic research consultancy specialising in the UK economy. Prior to this, Phil spent 10 years on the sell-side, with his previous role being at Nomura as a Senior European Economist.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)