Interest Rates Remain Unchanged

After the March Monetary Policy Committee meeting the market was pricing in a 90% chance of a Bank Rate hike at the May 10th meeting. The March meeting’s Minutes said that the economy had progressed as expected since the forecast update in the February Inflation Report and that “the May forecast round [with an updated Inflation Report due] would enable the Committee to undertake a fuller reassessment”. A clear hint that a rate rise was pending.

In the run up to the May meeting the implied probability of a rate hike, reflected in the pricing of short-dated money market contracts, had dropped to 10%. In the event, the market’s change in view was correct as the MPC left interest rates on hold. A change in view which was one of the largest swings over the course of just a few weeks that we have seen for some time.

What happened? Not an academic question, for to understand where the MPC is going with its policy decisions requires some untangling of why its view changed so dramatically. The first clear sign that the view within the BoE had changed was an interview Governor Carney gave with the BBC on April 20th. The data, he said, had been “on the softer side”. While an interest rate rise was “likely” this year, he added the Committee “was conscious there are other meetings over the course of the year”. If the data before Carney’s comments had been “soft” then subsequent releases were softer still. The first estimate of Q1 GDP came in at a meagre 0.1% rise on the quarter (the Bank in February had been expecting a 0.4% gain) and retail sales and business surveys were poor.

The current Bank view is that most of this “softness” was due to the weather: “the Beast from the East”. So just a “temporary soft patch” with the expectation that Q1 GDP data may well be revised up in subsequent releases and that growth will be back on track in Q2 (0.4% again expected). So from the Bank’s perspective, just a delay in its plans, with still the intention of higher Bank Rate to come albeit at “a gradual pace and to a limited extent”.

The possible problem with the MPC’s view is the extent to which the slowdown in Q1 was indeed very largely a distortion. The ONS said at the time of the release of the Q1 GDP data that the weather impact had been “relatively small” with the large hit to construction activity in part offset by higher energy output and strong online sales. Business surveys were weak in March (when the bad weather hit) but have shown virtually no bounce in April. So the risk is that while the weather did undoubtedly depress activity to a degree, there might have also been something of a more fundamental slowdown, perhaps linked to the Eurozone economy losing momentum early this year.

The net result is that the MPC is still looking for a window of opportunity to get Bank Rate up. It is clearly uncomfortable with what is still – at ½% – an extraordinarily low level of short rates. When will that window open? The next Inflation Report with its new economic forecasts will be in August, by which time we will have seen the Q2 GDP data. Then, we will have a better feel for the underlying growth position and the extent of the Q1 weather distortion. But if the Q2 activity data come in on the weak side, then the MPC might again struggle and a Bank Rate hike could be pushed into the latter part of the year.

By John Shepperd; Economics Adviser to Butler Toll Asset Management

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