This piece argues that last week’s susprising-hawkish MPC vote and minutes do not represent a dramatic change in the picture for UK monetary policy. The limits to the MPC approach of looking through temporarily above-target inflation, driven by sterling’s post-referendum depreciation, are further from being reached than the minutes-related headlines suggest. So the limited rebounds in MPC rate expectations and sterling should be faded (indeed $/£ already retraced a little on today’s announcement that article 50 will be invoked on 29 March). The main points are:
- The impact of Forbes rate hike vote is reduced by her impending departure, while the MPC minutes reference to “some members” being close to also thinking about rate increases seems most likely to apply to McCafferty and Saunders but less to others.
- The hawkish shift appears inconsistent with news on the three key judgements underpinning MPC’s central outlook for the economy – there’s been downside news to both inflationary pressure and growth prospects since the February IR.
- Consumption risks slowing more than MPC expect because the projected significant fall in the savings ratio to below 4% is open to question. That’s only occured once before over the past 50-plus years(!), it’s inconsistent with prospective elevated uncertainty and is contradicted by survey evidence.
- The hope that UK growth will be supported by net exports seems likely to be disappointed given structural headwinds (see my previous piece), although global demand prospects have improved in recent months.
- But the hawkish minutes comments will likely raise market sensitivity to inflation news (e.g. should CPI rise above 2% as expected on 21 March) and MPC commentary.
MPC showing surprising hawkish signs: unclear how widespread but
Last week’s MPC decision/minutes contained two relatively hawkish surprises.
First, Kirstin Forbes voted for a 25bp rate hike. The rationale was that “the monetary policy trade-off had evolved….Inflation was rising quickly and was likely to remain above target for at least three years….combined with global reflation and minimal labour market slack…upside risks to inflation. On the other side of the trade-off, the weakness in activity expected since the referendum had not materialised. Unemployment showed no signs of increasing. Although consumer spending appeared to be softening, as expected, growth was likely to be supported by other components of demand, such as net exports.” Given that Forbes is a well-known hawk and will any case be leaving MPC after the June meeting (i.e. will vote only twice more) her rate hike vote is of limited importance per se.
But the second, potentially more significant hawkish piece of news, was the minutes’ revelation that other MPC members seem relatively close to following Forbes in arguing for higher rates. Specifically, para 28 argued that: “with inflation rising sharply, and only mixed evidence on slowing activity domestically, some members noted that it would take relatively little further upside news on the prospects for activity or inflation for them to consider that a more immediate reduction in policy support might be warranted.” Unfortunately, the crucial issue of how widespread this view is within MPC is unclear. The phrase “some members” implies that a maximum of three additional members fall in this camp: if four or more had the phrase “most members” would have been used. But it also seems likely it’s not just the other well-known hawk Ian McCafferty (dissenter who voted for 25bp increases between August 2015 and January 2016). And Michael Saunders seems like a good further candidate for the potential rate hike camp, given his previous comments on the post-referendum resilience of the UK economy (which he attributes to the absence of a credit freeze).
But only six weeks since the February IR it seems a larger stretch for other previously-dovish MPC members to have changed their minds. Moreover, I argue below that (i) the hawkish shift appears surprisng in light of the three key judgements underpinning MPC’s central outlook for the economy; and (ii) consumption risks slowing more than MPC expect because the important projected significant fall in the savings ratio is open to question; (iii) Forbes’ hope that UK growth will be supported by net exports could disappoint (see my previous piece).
Given this, I would fade the associated market moves, although they are relatively-modest.
– UK interest rate expectations (OIS rates) rose by 5-8bp across maturities (see chart). But that just reverses part of the declines which occurred after the more dovish than expected February IR.
– £/$ rose from 1.225 to close to 1.24 (see chart), also helped by the Fed’s relatively dovish 25bp rate hike (virtually unchanged economic projections or dot plot). The post-minutes €/£retracement in was even smaller (from 0.875 to around 0.867) and again only unwound part of recent moves (in part driven by the ECB’s mildly less dovish language).
Hawkishness inconsistent with MPC’s three judgements
The apparent hawkish MPC shift looks susprising in light of the three judgements underpinning MPC’s central outlook for the economy: (a) “the lower level of sterling continued to boost consumer prices…without adverse consequences for expectations of inflation“; (b) “regular pay growth did indeed remain modest, consistent with….slack in the labour market“; and (c) “hitherto resilient rates of household spending growth slowed as real income gains weakened, without a sufficient offset by other components of demand.” Indeed, the MPC minutes acknowledge reduced inflationary pressure in both (a) and (b) and “mixed” activity news on (c), where I’m more negative. So on MPC’s own terms there isn’t a strong case for turning more hawkish only six weeks after the February IR.
On (a) the minutes argue that January’s 1.8% y/y CPI outturn was weaker than expected and that on balance inflation expectations hadn’t changed much. On balance I’d agree. The first chart below shows that financial market inflation expectations have fallen since February. And the second chart illustrates that near-term survey based real-economy inflation expectations have risen to elevated levels (z-scores of ) in recent months. Note that while the minutes only mention household inflation expectations the rise is broader, encompassing retailers, industry and the service sector. So I’d worried that the minutes could turn hawkish because of this, although the inflation expectations in the chart are all near-term ones and the BoE/TNS 5-year ahead consumer inflation expectation measure has been more stable.
On (b) the minutes argue that wages have also been weaker that expected, despite unemployment falling further. But that discussion doesn’t seem to capture the fact that real AWE regular pay growth has already fallen to it’s lowest since 2o14, only 0.8% y/y on a 3-month basis and 0.0% on a single-month basis. On one level this this supports the MPC’s February decision to reduce their UK NARU estimate by 0.5pp to 4.5%. But the fact such weak pay growth is occurring when unemployment is only maginally above the NAIRU (4.7%, the lowest since 1975), plus when both employment and avarage hours worked have re-strengthened, raises the issue that Bank staff’s NAIRU recalibration could be too conservative. So we could again see MPC forecasts be too optimistic on AWE growth i.e the recent persistent negative forecast errors on AWE could continue (see Chart). Indeed, the February IR forecast anticipates AWE growth picking up to 3% in 2017 and 3.25% in 2018 and 2019.
On (c) the minutes argue that the news on aggregate demand had been “mixed”. That seems a bit generous – the activity news appears on balance negative to me, although the picture remains one of a slow-burn impact rather than abrupt slowdown. The minutes acknowledge the “notable” weakness in retail sales volumes in recent months, down to -0.5% on a 3m/3m basis (weakest since February 2013) with the ex fuel measure being only marginally stronger (see Chart). Indeed, we can’t rule out headline retail sales falling for a fourth consecutive month in February (data 23 March), which would be fairly unprecedented. And the minutes seems to place a bit too much weight on the “steadier” consumer confidence as a counterbalance to retail sales weakness given that: (i) it’s steady at relatively subdued levels; and (ii) forward-looking major purchases components remain significantly weaker than current major purchases, consistent with consumers bringing forward purchases before the prospective big price rises come through (as firms’ FX hadges expire).
The minutes’ policy section also didn’t mention the January weakness in industrial production (-0.4% m/m, reducing the y/y rate to 3.2% from 4.2%) – while that mainly reflected a very sharp drop in pharmaceuticals, other manufacturing barely rose (see Chart). Alongside that, the manufacturing and services PMIs have both retraced (see Chart) with the composite measure pointing to GDP growth slowing from 0.7% in Q4 to only 0.4% in Q1. The NISER GDP estimate also suggests a growth slowdown, albeit at a higher level (0.6% 3m/3m in February from 0.8% Nov-Jan), on signs of softening conssumption support.
MPC risks being too optimistic on consumption: will savings ratio really fall to historic low?
The February IR revised up MPC’s growth forecasts – to 2.0% in 2017 from 1.4% previously – given that “Growth has remained resilient since the referendum, with the UK posting the fastest rate in the G7 last year.” Within that, the table below illustrates that consumption growth forecasts were revised up to imply only a mild consumption slowdown (bottoming out at 1% y/y in 2018) even though the post-tax household income forecasts were revised down (to only 1/4% in 2018 from 1% previously). This circle is squared by the household saving ratio forecast to be revised down – to less than 4%.
To be fair to the MPC, the February IR acknowledged the risk of getting this judgement wrong by arguing that “If, however, households react more sharply to uncertainty or the prospect of weaker income growth, they may be unwilling to reduce their saving rates to the extent projected.” But they described the risks as two-sided, with potentially stronger consumption (lower savings) give that “it is possible that households will take advantage of relatively low borrowing costs to maintain a higher rate of consumption growth even as income growth stalls.”
While there’s obviously been lots of recent post-referendum upside news on the UK economy I’d still place more weight on the downside risks on consumption via upside risks to the savings ratio.
– First, big-picture the relatively short sample period in the IR chart reproduced above somewhat obscures just how unusual a sub-4% household savings ratio is. The chart below rectifies this and shows that since 1963 (when the data start) this has happened precisely once and a very long time ago (1963 Q2)! The most recent low was 4.3% in 2008 Q1, while the post-1963 average is 9.3%.
– Second, basic economic theory indicates that the precautionary savings rise at times of uncertainty, which seems likely to be above-normal during the next two years of Brexit negotiations (even if Forbes (2016) makes some good criticisms of the BoE uncertainty summary measures).
– Third, the GfK/EC surveys shows consumer’s future savings intentions rising not falling (see Chart below)
Net exports also likely to disappoint, providing less offset to consumption weakness
My previous previous piece from January argued that there were structural and cyclical reasons for suspecting that UK net exports would fail to live up to expectations of being boosted by sterling’s significant post-referendum depreciation. The table above illustrates that the February IR forecast UK export volume growth to exceed import volume growth by 1pp in 2017, 1.25pp in 2018 and 0.75pp in 2019 (even though export volume growth itself slows) with commensurate positive GDP contributions. But, my previous piece illustrated: (i) The muted export impacts following previous sterling depreciations, as exporters have raised margins rather than targetting new markets; (ii) how previous sterling falls haven’t halted rising import penetration, reflecting a lack of UK substitute products; and (iii) How Brexit uncertainties could inhibit the investment needed to exploit new foreign markets and/or create UK subsitute products i.e. exacerbating (i) and (ii).
And since my previous piece it’s become pretty certain that the UK will leave the EU single market and the customs union, with associated uncertainty about the level of tariffs on UK exports/imports. And UK services exports, with a significant surplus compared with the trade in goods deficit, seem likely to be especially vulnerable to falling back on WTO rules. Conversely, there’s been upside news on global growth prospects since my analysis, which should help UK exports if the UK can produce the right products.
The recent trade data obviously contain very limited information on this slow-burn issue. But for the record UK export volumes continue to lag import volumes on a y/y basis, although relatively-strong m/m growth rates were reported in December and January (see chart). And UK export prices continue to outpace import prices, contrary to the simple textbook prediction.