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February 2011 Newsletter
Rate hike odds shorten despite weak GDP
Last month's note suggested that the MPC vote would shift in a hawkish direction in January, with another member supporting Andrew
Sentance's long-standing call for a rate hike. This was based on an "MPC-ometer" model that attempts to predict the monthly vote
based on incoming economic and financial information – see below for details. (This model was introduced in the September 2006 note
and correctly signalled the month and direction of 12 out of 13 subsequent interest rate movements – two more than the mean
economists' forecast in the monthly Reuters poll.)
Minutes of the January meeting revealed that Martin Weale had joined Dr Sentance in voting for a quarter-point rise. For at least one
other member, moreover, the decision about whether to raise rates was "finely balanced", with a key argument for delay being the
opportunity to conduct a more thorough assessment, and explain the Committee's change in thinking, in the February Inflation Report.
The minutes suggested little if any support for the views of Adam Posen, who continued to vote for an expansion of asset purchases.
Two major developments have occurred since the January meeting. First, the Office for National Statistics (ONS) released its
preliminary fourth-quarter GDP estimate, showing a 0.5% contraction. The headline figure is less significant than the official
assessment that GDP would have been "flattish" in the absence of bad weather disruption – a much weaker performance than
expected by the MPC and the consensus. (The ONS assessment is questionable: monthly information indicates that weakness was
isolated to December while GDP rose by 0.6% in the three months to November from the prior three months, suggesting a respectable
pre-weather trend – see first chart.)
Secondly, Bank of England Governor Mervyn King delivered a keynote speech giving the most forceful expression to date of his view
that the current inflation overshoot reflects "a series of unfortunate events" and that the MPC would have been wrong to begin raising
interest rates last spring, as Dr Sentance advocated. Mr King seemed to be staking out his opposition to a rate hike while issuing a "Do
you feel lucky?" challenge to the hawkish camp. The Governor may reckon that, with Dr Sentance's term finishing in May, the hawks
will lose momentum if defeated in February.
For many, these two developments represent a "game-changer", solidifying the prospect that Bank rate will remain at 0.5%, at least
through the first half of 2011. This, however, is not the message from the MPC-ometer. Even after incorporating the ONS estimate of
flat underlying GDP in the fourth quarter, as well as a further fall in consumer confidence in January, the model suggests that the
hawks will gain further ground in February. Assuming that Dr Posen continues to vote for easing, the forecast is consistent with a 4-4-1
split, implying no change in February but leaving the Sentance camp well-positioned for a rematch in March, possibly armed with data
suggesting a strong bounce-back in GDP in the first quarter.
Why has the model shifted further towards a rate hike? Fourth-quarter GDP weakness is given significant weight but has been offset by
components measuring inflationary expectations: the net percentage of consumers expecting faster inflation reached its highest level
since 1994 in January, while business price-raising plans have strengthened further – second chart. Drs Sentance and Weale have
emphasised the risk of expectations becoming detached from the 2% target and the latest evidence is likely to carry significant weight
with the waverers. The model has also been influenced by solid January business survey activity readings suggesting that GDP is
rebounding similarly to February / March 2010, following bad weather disruption in January – first chart.
The consensus view is that any upward move in interest rates over coming months will be minor: the mean economists' forecast is for a
Bank rate of 1.0% in March 2012, according to the Reuters poll. This, however, would be at odds with previous post-recession
tightening episodes. Official rates rose by 5.0, 3.8 and 1.5 percentage points respectively over 12 months from lows reached after the
1973-75, 1979-81 and 1990-91 recessions. In the latter two cases, moreover, the starting level of real interest rates was positive, in
contrast to current heavily-negative readings.
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MPC-ometer technical details
The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee's members. For example, if five want
to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is
assumed that votes are either for no change or a move of 25 bp – reasonable under "normal" economic and financial conditions – then
the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp.
The MPC-ometer's 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity,
inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer
prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business /
consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial
conditions.
The forecast weighted-average interest rate vote for February is +9 bp, consistent with either three members voting for a quarter-point
rise or four votes for a hike offset by one vote for easing.
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Disclaimer: The information in this communication is directed at Professional clients only. Information about past performance is not a guide to future
performance. The investor may not get back part, or all, of the amount originally invested. The value of your investment and the income from it is not
guaranteed and can fall as well as rise due to interest rate movements. Source: RLCM as at 31st August 2010, unless otherwise stated.
Royal London Cash Management Limited is a company incorporated in England and Wales (registration number 1963229) and is authorised and
regulated in the UK by the Financial Services Authority (registration number 121844). RLCM is a subsidiary of the Royal Londo Mutual Insurance
Society Limited which is registered in England and Wales with the registration number 00099064 and has its head office at 55 Gracechurch Street,
London EC3V 0UF.
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