The MPC has hiked. What next for interest rates?


Last Thursday saw the Bank of England vote unanimously 9-0 in favour of raising the base rate to 0.75%; only the second rate rise for more than a decade and the first time the rate has been above 0.50% since March 2009. In addition, no changes were made to the BoE’s quantitative easing program. The hike marks a watershed moment that puts the UK economy on the path to monetary policy normalisation.

 

Markets were already pricing in a 90% probability of a rate hike prior to the meeting so it was no surprise when Sterling jumped against the Dollar to 1.3124 on the announcement that there was going to be a rate hike; essentially pricing in the remaining 10%. What caught markets off guard however, was the fateful words of Mark Carney saying: “policy needs to walk not run to stand still”. This sent cable eventually down more than a cent down to a low of 1.3016 on the day.

 

Figure 1: Daily GBPUSD movements around the MPC decision (2nd August 2018)

 

 

  1. The Bank of England announces a hike of the base rate up to 0.75%.
  2. During the post-announcement Q&A, Mark Carney’s comments around future rate hikes send Sterling lower on the day.

 

The Bank’s view is that the UK labour market is tightening, unemployment is falling, and the economy does not have that much slack left in it. This will increase inflationary pressures going forward which were 2.4% in June this year (CPI); above the 2.0% target. For now, controlling inflation before it has a chance to get away is the main priority. The MPC was quoted as saying:

 

“Were the economy to continue to develop broadly in line with its Inflation report projections, an ongoing tightening of monetary policy over the forecast period would be appropriate to return inflation sustainably to the 2% target at a conventional horizon”

 

– MPC Committee Report

 

What does this mean? Well, it means that any future interest rate rises are likely to be at a gradual pace and limited in their extent. The UK will not engage in a tightening policy like that of the USA but on a much more gradual path that will be limited to one, maybe two hikes per year by 25 bps.

 

The MPC’s minutes also had a distinctly political theme to them. The Bank has been vocal in its opinion on Brexit’s effects on the wider economy and their view is that Brexit continues to weigh on business investment. The MPC has pinned future rate rises on a smooth Brexit but has hinted that they are cautiously waiting to see what kind of deal the UK ends up with before going ahead with future rate rises, or even cuts.

 

In addition to the standard minutes, the BoE also published guidance on it’s R* rate; the interest rate at which inflation and growth are stable when the economy is operating at full capacity. Although there is some disagreement over what this rate should be or even if it exists, the view has been taken by the MPC that this rate is somewhere between 2% and 3%; much lower than the 5% rates we were used to pre-2008. Underlying this step change are demographic factors such as ageing population, increase life expectancies and slowing population growth, as well as the far lower productivity growth that the UK is experiencing.

 

This is reflected in the LIBOR curve, which shows market expectations for 3m GBP LIBOR. Currently, the market is predicting gradually rising interest rates for the next three years before LIBOR rates begin to plateau in late 2023 / early 2024 around 1.65%.

 

Figure 2: Market Implied Future 3m GBP LIBOR Rates (as of 6th August 2018)

 

 

In all, markets and the Bank of England are now aligned in their thinking of how interest rates are set to develop in the UK over the next few years. Mark Carney’s approach has been data driven and cautious, but as he is set to leave in June 2019 it is unclear whether the next Governor will continue this cautious path. Ultimately though, the economy and Brexit will also play their role in deciding where rates end up going in the future.

 

 

 



 

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