August 24, 2015    5 minute read

UK Monetary Policy Change is Just Over the Horizon

   August 24, 2015    5 minute read

UK Monetary Policy Change is Just Over the Horizon

Now is a time when investors and policy makers are beginning to question when the Bank of England will initiate an interest rate hike, following its six-years near the zero bound level of 0.5%. Elevated anticipation of a rise in interest rate stems from ‘Super Thursday’ inflation data, indicating that UK’s CPI has returned to positive territory, from zero to 0.1% in July. The UK’s highly volatile CPI has been below the central bank’s target of 2% for the last 19 months, and fell into negative territory in April for the first time in the last half century. The Office of National Statistics (ONS) claimed that the underlying reason behind the inflation growth was due to fewer general discounts in the summer sales, in addition to an increase in airfares, despite the recent plummet in oil prices. These upward-riding factors were partially undermined by tumbling food prices. However, an increase in summer bargains is hardly substantial evidence to influence the Monetary Policy Committee (MPC) to show its hand.

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The central bank’s enthusiasm about the UK economy’s current situation and near-future beckons a rate hike. For the first time, the Bank of England communications format included the inflation report together with the interest rate decision and MPC minutes. It is predicted that the economy will expand by 2.8% this year, up 0.3% from the past forecast, partly due to anticipated oil price recovery. This should be well underway by the end of the year, in turn heightening inflation more considerably than the 0.1% increase.

A significant decrease in unemployment rate – now standing at just 5.6% – is also a convincing indicator of a rise in interest rates. A tightening labour market implies that the UK is close to full employment, in comparison to its EU neighbours. Not only has the ratio of job vacancies to unemployment been restored to pre-crisis levels, but also the proportion of people unemployed for less than a year. Consequently, the central bank has projected a 4% increase in wages by 2017. With wage-growth picking up, employers would have the ability to increase wages whilst perpetrating an upward spiral of inflation and avoiding mounting prices.

However, Bank of England governor Mark Carney, has expressed a few concerns with an proximate change in monetary policy. After a six-year sojourn of a 0.5% interest rate, any stint will affect markets significantly. In turn, this would heighten the effect of a shift in the rate, as well as perhaps offset economic recovery. It is also feared that delaying a shift in interest rate – due to the anticipated disproportionate impact on markets – would lead to a frantic response in the future. This would cause further anxiety for businesses and investors, who would, as a consequence, lose a weighty amount of their usual monetary fix.

This second concern has led to great differences between the Institute of Directors and the British Chamber of Commerce. Whilst the Institute of Directors are urging the MPC to vote a 0.25% interest rate increase at its meeting next week, the British Chamber of Commerce believe that a proposed hike would highlight the ‘fragility of the economic recovery, especially in the face of a highly uncertain international backdrop’. The most tangible solution would be for the Bank of England to shift interest rates slightly less than the conventional 0.25%. Therefore, a 0.1% interest rate increase sounds judicious, as it would not only prove that the MPC is able to stand its ground, but also be understanding to the angst felt by markets and businesses.

Despite an interest rate hike appearing to be just around the corner, there are several reasons why we shouldn’t expect a shift anytime soon. Annual inflation is likely to continue to be volatile, bouncing around zero as it has been doing for recent months, thus fall as well as rise. This month will present more official numbers for inflation, but the recent drop in commodity prices will be likely to decrease inflation. For instance, the cost of crude oil has decreased by 20% within the last month. However, this figure was released too late to be included in July’s CPI. Furthermore, the currently strong sterling – which has had a 6% trade-weighted index since January – has ensued cheaper imports. This has done particular favours for manufacturers, whose cost of fuel and raw materials fell by 0.9% last month. However, the robust pound is offsetting inflationary pressure, thus contributing to the hold back of an interest rate increase.

The MPC has warned that an interest rate hike is just over the horizon, although we can only speculate when because their exact trigger for such an action has not been disclosed. After a recent major monetary speech given by Carney, it is suspected that a rate rise will be introduced as early as January 2016.

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