BOE preview: becomming more dovish but wanting to see more data

Thursday’s MPC decision and minutes represents an important test of the MPC’s downplaying the impact of international (China/EM) developments on the UK economy and whether MPC want to push back on the substantial repricing of BoE rate hike expectations. Overall, I suspect that they’ll tweak their language to be a bit more dovish but signal a desire to look at the data more carefully in the run up to the November Inflation Report before they conclude that its all doom and gloom (i.e. that there’s been a fundamantal change to the international environment and UK inflation dynamics).  Indeed, they could well reference several continued bright spots in the economy.  But the considerable uncertainties mean that they’ll also avoid strongly pushing back against current strongly dovish market pricing.

The vote itself is unlikely to be where the action is: another 8-1 looks likely given that MPC will not have a new forecast set to consider until next month (non Inflation Report months tend to be associated with treading water). Rather the main interest will be the language describing the impact of international develeopments.

Specifically, Markets have inferred that the Fed’s 17 September concerns about the impact of China/EM slowdown on the US (“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”) must apply in spades to the more open UK economy. And they haven’t bought FOMC hints that 2015 rate hikes remain on the cards. So the market expectation is that the MPC will have to tone down its relatively sanguine language on international developments (“Global developments do not as yet appear sufficient to alter materially the central outlook described in the August Report, but the greater downside risks to the global environment merit close monitoring”) and Carney’s previous view that a rate hike decision would still come into focus around the turn of the year. That direction of travel towards a more dovish MPC is undoubtedly correct.

But given how much market prices have already moved the risks are skewed to strongly dovish exectations being disappointed.  Indeed there’s a small potential for MPC to push back against the repricing a little.  Recall that in August Carney warned that inflation risked overshooting the target if the yield curve didn’t steepen. And the centre of gravity on the MPC has seemed to be attracted to the argument that starting raising rates earlier helps ensure that the eventual pace of rate hikes can be gradual (as long as its not so premature as to risk being reversed). So market pricing of an early-2017 rate hike, with UK rate hikes being pushed back by more than US rate hikes, seems to have risks skewed towards eventually repricing earlier. But the odds seem a bit stacked against that risk eventuating near term given general market sentiment and some evidence of internation spillovers to the UK.

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Specifically, the sharp slowdown in the services PMI, to its weakest since April 2013 and actually slightly below the EA equivalent, reduces the chances of MPC pushing back against the dovish market expectations in the near-term.  Indeed, Markit attribute the services PMI fallback to international developmentsWeakness is spreading from the struggling manufacturing sector, hitting transport and other industrial-related services in particular. There are also signs that consumers have become more cautious and are pulling back on their leisure spending, such as on restaurants and hotels. Wider business service sector confidence has meanwhile also been knocked by global economic worries and financial market jitters.”  If true it’s quite a scary prospect for the UK catching a cold so soon after China has sneezed, given the UK’s limited trade links with China (see here), which MPC will want to take that possibility seriously.  But they will also likely be reluctant to substantially policy shift based upon a single information source. So there could well be mixed/nuanced messages in the minutes, including a desire to examine further data (rather like the Fed!) rather than definitively endorsing the very dovish new market path.  MPC may also be sensitive to renewed “unreliable boyfriend” criticisms, although they always said they were going to be data dependent.

That said, the sharp fall in the services PMI does look a bit challenging alongside the recent acceleration of service sector wage growth, although the PMI is more timely.  And that contrasts with the flat US wage growth picture: the tight UK labour market shows signs of supporting domestic inflation.  Similarly, UK consumer confidence has retraced less than in the US, with the major purchases component remaining elevated in September (contrary to the Markit reports of consumer caution).  UK inflation breakevens also continue to be a picture of stability relative to their apparently oil-influenced US and EA equivalents.  And last week’s GDP release also featured upward revisions to previous years (from 1.7% to 2.2% in 2013) as well as a significantly smaller current account deficit (3.6% of GDP in Q2 versus 6.3% in Q4) supported by a less dire net export picture, despite sterling’s elevated level.  MPC will also likely not be disappointed that sterling’s previous upward trajectory has reversed somewhat alongside the more dovish UK rate expectations, although they have generally been pragmatic (see here). But Kirsten Forbes argument that GBP’s recent strength was less deflationary because of its particular origins (reinvigorating a line of analysis I promoted within the BoE) may yet be resurrected in an eventual hawkish case.

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That said, MPC doves may well start making more of the fact that non-oil GDP growth seems to have recently slowed to around 0.4% qoq in H1 from closer to 0.8% qoq in 2014. In other words, government tax incentives look to have caused a surge in oil output which has supported headline GDP by 0.2pp (and also seems to have helped support this morning’s better than expected industrial production data).  But given low oil prices and the high north sea extraction costs we wouldn’t expect that relatively-strong boost to persist: so PMI forecast of 0.5% GDP in Q3 (in line with the NIESR estimate) and 0.3% in Q4 may not be unreasonable.  Moreover, the much-trailed UK fiscal consolidation will start kicking in over the coming months, although it should already be incorporated in the MPC’s forecasts.

The continuing apparent close links between GBP and policy rate expectations suggest that sterling could get a boost if and when the risks of UK rate hike expectations being brought forward again eventuate.  But there are several caveats: (a) the trigger for a reappraisal could be the Fed surprising by starting hiking earlier than expected (perhaps even in 2015 even though I argue here that there’s no real cost of delaying into 2016) so UK-US rate differentials might not narrow and GBP’s pro-risk characteristic would be negative if risk appetite is damaged; (b) the timing could coincide with growing BREXIT concerns which would work against the interest rate support: last month I discussed how Jeremy Corbyn’s likey election as Labour party leader could adversely impact the pro-EU ” case and the EU migrant crisis seems to have contributed to falling support for UK EU membership (several recent opnion polls have reported small leads for “leave EU”).  Markets may start taking such polls more seriously as the (undefined) referendum date approaches and if Cameron doesn’t look likely to secure the desired (opaque) concessions.

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