COVID | Monetary Policy & Inflation | UK
Brexit uncertainty, the UK’s economic makeup, a dovish sounding Bank of England and a possible early end to fiscal stimulus are all reasons the UK recovery may lag others in G10 and mean looser monetary policy ahead. We think these concerns are overdone.
Since May 2020, short-term interest rates in the UK have fallen by more than their equivalent in any other developed market – with 1y1y swap rates moving around 22bps lower (Figure 1). In absolute terms, the 3m1y spread in the UK is the second lowest across G10 rates markets (only New Zealand has a more inverted curve at the front end). We think the relative pessimism expressed in the UK rates market may be unjustified when assessing the potential reasons for why this may be occurring.
Why Do Markets Have Greater Conviction Over Lower Policy Rates in the UK Relative to Other Major Economies?
1. Pessimism over the UK economy – is it just as simple as Brexit trade deal uncertainty?
First, the shock of a cliff-edge Brexit would be a fraction of the damage that has already occurred due to the nationwide lockdown earlier this year. And while it would inevitably slow the UK economic recovery, a marginal Bank rate cut will add little impulse given that demand is already at historically weak levels and interest rates are at record lows. Instead, the negative supply-side impact of a cliff-edge Brexit – and a much weaker trade-weighted pound – may put upward pressure on UK inflation expectations. This makes the policy decision in the event of a cliff-edge Brexit much harder for the Bank of England – and we don’t think UK rates market are adequately reflecting this trade-off.
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