Where next for interest rates?

By John Shepperd; Economics Adviser to Butler Toll Asset Management

When the Monetary Policy Committee (MPC) decided to raise Bank Rate (from ¼ to ½%) last November, it was not seen as much of a real tightening. More a reversal of the post-Referendum cut, taking back an insurance policy that was not needed. The Bank of England’s (BoE) view then was that rates would go up in the future, possibly twice in the ensuing three years. But it was all rather vague, giving the impression that the MPC was in no real hurry.

This week’s Inflation Report, and the associated Summary of the MPC meeting, rather changed that view. The key phrase from the MPC’s deliberations was:

Were the economy to evolve broadly in line with the February Inflation Report projections, monetary policy would need to be tightened somewhat earlier and by a somewhat greater degree over the forecast period than anticipated at the time of the November Report.

What has changed? Back in November, inflation was well above the 2% target – around 3% – but this was thought to be the result of the devaluation shock. That would work through the system and there were no signs of any domestic inflation consequences – the one thing that might have got the BoE worried. Now, there are concerns that while inflation will be coming down, there is the risk of domestic inflation pressures. And that risk is what the MPC is reacting to.

The argument that ran through the latest monetary policy discussion by the MPC is straightforward. Growth has been better than expected. Growth forecasts have been revised marginally higher. The trend, sustainable, growth rate is now lower than in the past. So “the remaining very limited degree of spare capacity was absorbed more quickly”. The unemployment rate is at what is usually thought to represent full employment. There have been signs of some pick-up in wage settlements. Crucially, “a further marked rise in annual earnings growth was likely in coming months”. If so, monetary policy tightening takes on a greater degree of urgency.

So as ever, the Bank’s view is based on a forecast – inevitable given the time lags between changing Bank Rate and its consequences for the economy. Policy has to be forward-looking. But as we know, forecasting is a hazardous, error-prone, exercise.

What is key in this is the pace of growth of wages and its official measure, average earnings. Recently quite stable at around 2½%. A stability which has been considered surprising given the drop in the unemployment rate. So what the MPC is saying is that this stability is coming to an end and a policy response will be needed. So, the key data to watch is the annual rate of growth of average earnings, especially how this evolves through the traditional spring wage bargaining period. If the growth rate picks up, the MPC could raise Bank Rate this summer and plan further increases thereafter. If wage growth remains stable at around the current level, the sense of urgency may disappear and the MPC might have to reconsider.

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