Earlier Rate Rise For UK?

By Georgios Tsapouris, investment strategist at Coutts

The Bank of England (BoE) Inflation Report delivered an upbeat message on the UK economy, forecasting growth in gross domestic product (GDP) this year of 3.4%. BoE Governor Mark Carney moved away from explicit forward guidance on interest rates, hinting that the Bank could be less committed than before to keeping rates at the current level for a prolonged period irrespective of the strength of the economy.

As a result, we bring forward our forecast for when the Bank might first raise interest rates by one quarter to the second quarter of 2015. Nevertheless, we maintain the view that even if the first rate hike happens earlier than we previously expected, rates will remain extremely low and will rise at a much slower pace than in previous cycles.

The UK economy can’t afford materially higher rates due to its high borrowing levels. Carney also acknowledged that in the ‘new normal’, rates would not rise above 2-3% in the medium term, which compares with 5% before the crisis.

Carney moved away from linking monetary policy decisions to a single economic variable (until now unemployment) and refrained from providing time-dependent guidance.

The Bank will instead consider a broad set of indicators including measures of unused labour capacity. No thresholds were set for these variables and we see this as a return to good old-fashioned, data-driven monetary policy, where central bank decisions depend on the overall state of the economy.

This could indicate that some Monetary Policy Committee members aren’t convinced by forward guidance, and this increases the chances of a rate hike in response to a booming economy.

The BoE recognised the improvement in economic data and upgraded its growth projections, now expecting the economy to grow at 3.4% in 2014 (ahead of the consensus estimate of 2.6%) and 2.7% in 2015 (consensus 2.4%).

Despite accelerating growth, the inflation forecast was reduced, with the Bank now expecting inflation to remain below its 2% target for the whole three-year forecasting horizon, reaching a trough of 1.7% in 2015.

The BoE estimates that the output gap (spare capacity in the economy) is equivalent to 1.0-1.5% of GDP. Assuming that the UK economy can potentially grow at its ‘trend rate’ of 2.0-2.5%, if the economy were to grow this year at the BoE’s forecast rate of 3.4%, most of the output gap will have been removed by next year, when rates should start to rise.

We believe strong growth will continue to provide some short-term support for sterling. However, if the BoE decides not to raise rates until after 2015, sterling could be left vulnerable to a significant correction.

 

 

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