This piece previews Thursday’s Bank of England Feburary Inflation Report and MPC minutes, where the key issues will be: (i) how much longer can consumption continue to be the single engine generating UK growth?; and (ii) MPC remain tolerant of prospective above-target inflation? The main points are:
- MPC will as expected by the market undoubtedly remain on hold, letting their asset purchase programme end.
- MPC’s 2017 growth forecast will likely be revised up (to 1.6-1.7%) in light on recent continued resilient UK activity and better global momentum. The 2018 growth forecast will likely be little changed from the 1.5% anticipated in November, albeit with downside risks as MPC views Brexit-driven adjustment as having being delayed rather than avoided and potential payback for stronger near-term growth.
- Recent strong debt-fuelled consumption growth is set to slow as real incomes are hit by higher inflation, with wage growth likely range-bound. So consumers’ recent optimsm about their personal financial prospects seem likely to become more aligned with their pessimism about general economic prospects. Indeed, there’s already nascent slowdown signs of consumption momentum slowing in the high-frequency data.
- There’s little prospect for more balanced UK growth. Structural factors will likely constrain the net export boost from sterling’s depreciation (see my recent analysis). And surveys indicate continued weak fixed investment (see here), although MPC could cut the assumed negative impact of Brexit-related uncertainty (see Forbes (2016)).
- MPC’s inflation forecasts probably won’t change dramically from the 2.7% forecast for both 2017 and 2018 in November (although my personal forecasts are higher). The upward pressure from upside inflation news, stronger near-term growth prospects and the 7% rise in oil prices since November will be counteracted by the 16bp rise in 3-year OIS rates and £ERI’s 3% appreciation (see Chart).
- MPC will likely aim for a balanced/neutral message, reiterating that the next rate move could be either up or down. But at the margin the MPC message could be slightly hawkish: rises in household/market based inflation expectations (see chart) could start testing MPC tolerance of prospective above-target inflation although more evidence is needed.
- So while large market reactions are unlikely, the risks are skewed to further rises in market rate expectations and near-term sterling strength. MPC’s recent poor forecasting record and market myopia may result in greater focus on the near-term growth upgrade and any hawkish language (Carney will have to tread carefully).
- Any near-term sterling strength, however, faces likely longer-term headwinds from UK economic news turning more and Brexit negotiations hiccups. Plus markets have viewed sterling rallies as selling opportunities, as I anticipated October.
Continued Near-term UK data resilience: 2017 Growth forecast to be revised up
The well-known big picture is that UK activity data have remained resilient since the November Inflation Report, indeed frequently exceeding market expectations. For example, preliminary Q4 growth of 0.6% q/q exceeded both market expectations and the 0.4% BoE staff nowcast (December MPC minutes). Indeed, Q4 growth was an even stronger 0.7% q/q when the volatile oil sector is stripped out (see second chart). Within the components, the output was almost-entirely diven by the 0.8% q/q rise in services. And the detailed services data strongly suggested, that as in recent quarters, household consumption underpinned growth.
And MPC seem likely to follow other high-profile forecast outfits (IMF, NIESR) in responding to this better than expected near-term momentum by revising up their 2017 growth forecast. While MPC already revised 2017 growth up to 1.4% in the November IR (from 0.8% in August) 2017 growth around 1.6-1.8% now appears plausible (still down from 2.2% y/y in Q4). Indeed, Governor Carney strongly hinted at that direction at the TSC. While such a near term growth upgrade consequently should’t be a surprise, and has little policy relevance, the combination of market myopia and the MPC’s recent poor forecast record mean that markets could take a hawkish message from this.
Consumption has continued driving growth, but recently debt-fuelled
The more interesting development if, and how, MPC alter their 2018 growth forecast. Recall that the Novemer IR revised this down (to 1.5% from the 1.8% anticipated in August) so there could be resistance to further downward revisions.
The key here will be what happens to household consumption. The big picture is that while there has recently been upside news to consumption, which has continued to be the dominant driver of overall growth, that’s been fuelled by a mini debt binge that looks unsustainable (especially given the headwinds set to hit households). Moreover, BoE Governor Carney recently warned that consumption-led growth “tends to be both slower and less durable”:
- Solid 0.7% q/q consumption growth meant that it accounted for 0.5pp of Q3’s 0.6% growth, as UK net exports knocked 1.2pp off growth (their worst performance since Q2 2012) and business investment rose only 0.4%, thereby continuing the recent pattern of unbalanced UK growth.
- That occurred despite household disposable income falling 0.1% in Q3, so the savings ratio fell to only 5.6% (see chart), it’s lowest since Q3 2008. And that was despite the considerable uncertainties assocoiated with Brexit (the second chart show’s the BoE’s measures). This apparent lack of precautionary saving promted BoE Chief Economist haldane to note that “If you look at how the consumer performed during the course of the last year it’s almost as though the referendum had not taken place.”
- Consumer credit growth has picked up markedly – the 10.8% y/y growth in December was the strongest since 2005 (see 3rd chart below) although growth mortgage lending and hence total lending to individuals has been more muted.
- While overall consumer confidence remains subdued there’s a stark distinction between consumers’ relative optimism about their personal financial situation (possibly reflecting 52% having backed Brexit!) and willingness to undertake major purchases versus their continued pessimism about general economic prospects (see chart).
Consumption set to comes under pressure from weaker real incomes as inflation rises
On top of those strains, the consumer is yet to face the real Brexit-related challenges. Specifically, as MPC have flagged, growth of household real income is set to fall as inflation picks up further and wage growth likely remains muted. So consumers’ recent relative optimism about their the personal financial prospects (see Chart above) seems likely to become more aligned with their relative pessimism about general economic prospects.
My companion piece adopts a twin-track approach to arguing that inflation is set to rise further over the coming months.
- First, examining how inflationary pressures are growing in the supply chain: (i) there’s recently been upside news in both PPI and CPI inflation; (ii) there’s been a very close correlation between imported producer input price inflation and £ERI moves; (iii) Producer margins have been squeezed as output prices have risen less; (iv) Recent upside CPI inflation news hasn’t yet reflected components with high import intensities (although this isn’t unusual). Today’s manufacturing PMI provided furher evidence of the pressures: input prices rose at their fastest on record while output prices.
- Second, taking account of my previous research on how the CPI impact of a sterling move depends on the fundamental shock hitting the economy. Sterling’s depreciation seems to have been driven by a combination of higher FX risk premia and looser monetary conditions (see Sterling becomes unlovable), which tend to have larger CPI impacts (Forbes, Hjortsoe and Nenova (2015) reach similar conclusions.
Given that approach, my personal forecast is that inflation will be around 3% in 2017 and 2018 i.e. higher than the 2.7% forecasts from the November IR. Interestingly, the latest NISER forecasts are for 3.3% in 2017 and 2.9% in 2018
Turning to the labour market, several fundamental factors point to nominal wage growth likely remaining within the 2-3% range witnessed over the past few years, with risks of falls (nothwithstanding the small upside news in the latest release). Specifically: (i) UK employment has stopped growing and average hours ; (ii) The job vacancy to unemployment ratio, a key measure of labour market ‘tightness’ has fallen to it’s lowest level since 2005 (see Chart); (iii) Redundancies have picked up to their highest level since early 2014; (iv) Surveys of recruitment difficulty have fallen; (v) Structural labour market changes seem to have reduced the equilibrium unemployment rate: wage growth has consistently confounded MPC expectations of a pickup as the unemployment rate has fallen. See here for analysis by MPC member Michael Saunders.
Already potential signs of slowing consumption momentum
While the hit to houshold real income will be a slow-burn drag on consumption, there’s actually already nascent signs of consumption losing momentum. Specifically:
- Retail sales were the weakest since May 2011 in December (-1.9% m/m, core -2.0%, see Chart). And the CBI distributive trades survey indicates weakness in January.
- December’s 0.5% m/m consumer credit growth was the weakest since Febuary 2015, taking the longer-period growth rates off their multi-year highs (see Chart).
- Nationwide house price inflation has slowed to it’s weakest since November 2015. The end-2016 mortgage rate cuts seem to have provided less than expected support to the housing market, although mortgage approvals and lending remain steady.
- Consumer confidence
Probably only small changes to MPC inflation Forecasts
As mentioned above, my personal forecast is that inflation will be around 3% in 2017 and 2018 i.e. higher than the 2.7% forecasts from the November IR. But the task here is to analyse out how the MPC’s will have changed since November. And the combination of data news and changes to IR financial market conditioning variables and inflation forecasts probably won’t change dramically from the 2.7% forecast for both 2017 and 2018 in November.
Specifically, there will upward pressure on the MPC’s inflation forecasts from: (i) recent upside inflation news – ranging from import prices, producer input prices, average weekly earnings (AWE) and CPI inflation; (ii) stronger near-term growth prospects; and (iii) the 7% rise in oil prices since November. But such upward pressure that will be counteracted by the higher market interest rate expectations (3-year OIS rates are 16bp higher the in November) and sterling’s rebound since November (the £ERI is 3% higher, see Chart).
Inflation expectations rising: slightly less tolerance of near-term inflation overshoots
The November Inflation Report and Dccember MPC minutes signalled strongly that MPC will be paying close attention to the behaviour of inflation expectations in determining their tolerance to near-term inflation overshoots. Their warning that “there are limits to the extent to which above-target inflation can be tolerated” is all about whether the overshoot has knock-on second round effects – in consumer wage-price behaviour and financial markets. So the recent rise in several inflation expectations measures point to some limited increase in MPC hawkishness, although it’s not universal so they’ll likely want to see further evidence before getting serious. Specifically:
- Near-term household inflation expectations surveys have spiked. In January the European Commission year-ahead measure reached it’s second highest on record – and the highest, in January 2011, was a temporary blip whereas the current rise looks more sustined (se Chart). The Citigroup/Yougov year-ahead measure also rose to a 3-year high in January (2.6%).
- Medium-term household expectations, which MPC will place more weight but which there’s less timely data for, also show upward tendencies. Specifically, Citigroup/Yougov 10-year household inflation expectations of 3.0% in January were the highest since 2014. That said, the BoE/TNS survey 5-year household inflation expectations , although that series only goes to November.
- Medium-term gilt-market derived inflation compensation measures have risen sharply to around multi-year highs, although the situation is a little less dramatic than after sterling’s 2008 depreiation (see chart). While the December MPC minutes signalled greater faith in swap-based inflation breakevens, which have risen less, MPC won’t be able to completely ignore the rise in gilt-based measures.