With the recent monthly purchasing managers index behind us, we can look forward to this week’s Bank of England meeting and quarterly inflation report. Below Adam Chester, Head of Economics at Lloyds Bank Commercial Banking, discusses what to expect on Thursday’s meeting.
When the Bank of England meets this week, it could prove to be one of the most important policy meetings of the year.
What makes tomorrow’s update of particular interest is that it includes the annual deep-dive into the supply side of the UK economy, which has important implications for the speed and extent of future interest rate changes.
By assessing how the economy is performing in relation to its potential, the Bank can form a judgement about how much slack remains - the greater the slack, the greater the scope for demand to rise without pushing up inflation, and vice versa.
The Bank will give its verdict on whether demand is above what the economy can sustainably produce – the so-called ‘output gap’ – as well as how quickly the economy’s supply potential can rise – the so-called ‘trend rate’ of growth.
Before the financial crisis, the UK’s trend rate was estimated to be around 2.5% a year, but by last year it had dropped to 1.5%, largely down to a fall in productivity which has been blamed on Brexit uncertainty.
The Bank will also need to make a crucial judgement on how much spare capacity, if any, remains in the labour market.
A lack of slack
In last year’s update, the Bank concluded that the weakness of pay growth at that time suggested the labour market was operating with a small degree of slack. This no longer looks the case.
Over the past year, total employment has risen by over 400,000 to a new high, and the unemployment rate has dropped further – from 4.8% to a forty-two year low of 4.3%.
The latter is now below the Bank’s previous estimate of the sustainable, or ‘equilibrium rate’ of unemployment, which it put at 4.5%.
It is possible that the Bank could lower this estimate further, but to do so would likely raise eyebrows, as regular pay growth has started to accelerate – rising from an annual rate of 1.8% to 2.4% since last spring.
The Bank will also revisit its assumptions for population growth, the participation rate (the percentage of the adult population in the workforce), and hours worked.
The ageing population, declining immigration and changes in taxation and benefits will all have a bearing on this.
Overall, the Bank faces a tricky balancing act.
Arguing the case
If it is to conclude that underlying inflation pressures are likely to be benign during 2018, it needs to argue that either (i) the supply side is improving, most obviously due to rises in productivity and/or an increase in the amount of available labour; or (ii) that, for the time being, the outlook for demand is sufficiently weak.
On both counts, we suspect the Bank could struggle.
Firstly, there are no obvious signs of an upturn in productivity growth and recent increases in wage growth suggest the tightening of the labour market is starting to bite.
Second, there is little sign of any significant weakness in demand, with recent indicators confirming the economy is holding up relatively well.
Given this, we suspect the Bank will conclude that any spare capacity in the economy is continuing to be eroded.
While it is likely to cite ongoing ‘Brexit uncertainty’ as an argument for maintaining a ‘gradualist approach’ to policy, the implication is clear.
In the absence of a clear slowdown in demand, the Bank may have to raise interest rates more quickly and more sharply than either we, or the financial markets, currently anticipate.
Below, Paul Richards, Chairman of Insignis Cash Solutions, explains why the end of the TFS will have adverse effects on savers and banks.
28 February 2018 marks the end of the term funding scheme (TFS), a source of cheap borrowing for banks since its launch in August 2016. This ability to borrow at a low repayment rate meant banks didn’t need to rely on retail deposits for funding; the resulting increase in liquidity reduced the need for banks to compete for savers’ cash, putting downward pressure on deposit rates.
When the scheme closes, the appetite for retail deposits will increase, prompting more competitive rates for savers. The longer term impact will be even more significant. Banks have four years to repay money to the scheme, and will increasingly need to rely on retail deposits during this time.
Failure to repay TFS loans is not an option. After 28 February, the clock starts ticking to pay back £100 billion and banks need to factor replacing these funds into their long term strategic planning. Banks are likely to focus on building up retail deposits as these funds are classified preferentially under regulatory ratio requirements and tend to be more ‘sticky’ long-term.
While we don’t expect instant access rates to improve dramatically straight away, we expect savers to be increasingly rewarded for longer terms savings products. For both notice and term accounts there should be a long term improvement in the market as banks work to replace the Bank of England liquidity.
We also have an increasing number of new bank entrants to the market seeking deposits. There are 20 plus challenger banks looking to enter the UK market, a big boost for competition. Then there is the relative robustness of the UK economy to consider – this combination of drivers will help to push rates higher and increase the options available to savers.
It’s likely we will see a 0.25-0.5% increase in longer terms savings rates over the next 12 months and potentially up to 1% over the next 24-36 months, which could leave a one year term account getting close to the 3% level.
Failure to start Brexit trade talks at the EU summit in December could lead to “a difficult choice between two opposite policy stances from the Bank of England”, warns the senior investment analyst at one of the world’s leading independent financial services organisations.
deVere Group’s International Investment Strategist, Tom Elliott, is speaking out after the Bank of England (BoE) raised interest rates last week for the first time since 2007, and as senior officials in Brussels say the EU is unlikely to agree to trade talks in December unless the UK offers more concessions.
Mr Elliott comments: “The uncertainty over the UK’s eventual trading relationship with the EU is blamed by some for the weaker economic growth seen since the spring. Investment spending is being deferred or abandoned, with the long term impact being weaker productivity gains and wage growth than would otherwise occur. Sterling may fall victim to this uncertainty, and become a ‘big short’ on foreign exchange markets in December if an EU heads of government summit decides that no progress has been made on the divorce bill.
“They can then refuse permission for the EU negotiators to move on to discuss the post-Brexit trading arrangements, and a possible transition agreement. The UK government needs to show progress on this area, soon, in order to assure British business that an eventual deal will be had.. The longer talks on the future trading relationship are postponed, the greater the risk of no deal being in place by March 2019 when the UK leaves the EU, and the greater the disruption to the U.K economy.”
He continues: “This will put the Bank of England in a difficult spot - should it cut the bank rate to support the economy but risk a further fall in sterling, or raise interest rates further to support the pound? Keeping the currency attractive is important when the UK Treasury has to sell billions of pounds worth of gilts each year in order to support a 3.6 per cent annual budget deficit.
“The BoE will be under intense pressure to ‘support Brexit’ from influential Eurosceptic politicians, who have openly called for the Governor, Mark Carney to be sacked on grounds of his warnings over Brexit, both before and since the referendum.
“This means keeping rates low to help support the economy through the Brexit shock. Politics therefore favours letting the pound take the strain, even though gilt yields may have to rise to attract foreign buyers, increasing the funding costs of the government deficit.
“The Treasury is increasingly seeing Brexit as an exercise in damage control, but has limited fiscal tools at its disposal to support demand should Brexit go badly. There is no money for tax cuts or spending increases. This adds pressure onto the Bank of England to go easy on interest rate hikes.”
Mr Elliott concludes: “The Bank of England has presumably balanced the risks of a rate hike with the overall aim of normalising monetary policy and curbing credit growth, and has concluded that a slight dampening of demand now -while the economy is at least still growing- is better than leaving rates at record low levels that encourage over-borrowing by consumers.
“Brexit complicates setting monetary policy. And the BoE will be pulled in two different directions should the EU summit in December fail to make progress on the Brexit divorce settlement.”
(Source: deVere group)
European Central Bank (ECB) headquarters
European Central Bank (ECB) and Bank of England (BoE) have announced measures to enhance financial stability in relation to centrally cleared markets in the EU.
The ECB and the BoE have agreed enhanced arrangements for information exchange and cooperation regarding UK Central Counterparties (CCPs) with significant euro-denominated business.
A CCP places itself between the original counterparties to a transaction, effectively guaranteeing that if one counterparty fails, the CCP will continue to perform on the transaction to the other party. A CCP protects itself by taking collateral (‘margin’) from each party and by collecting a ‘default fund’ from its members to meet losses that exceed the margin it holds.
The ECB and the BoE are also extending the scope of their standing swap line in order, should it be necessary and without pre-committing to the provision of liquidity, to facilitate the provision of multi-currency liquidity support by both central banks to CCPs established in the UK and euro area respectively. CCP liquidity risk management remains first and foremost the responsibility of the CCPs themselves.
This announcement follows the judgement on 4 March 2015 by the General Court of the EU. In light of these agreements the ECB and UK government have agreed to a cessation of all legal actions covering the three legal cases raised by the UK government.
