Download Focus on: Will financial policy be tightened before monetary policy?

Focus on: Will financial policy be tightened before monetary policy?
FIG. 6 MARKET INTEREST RATE EXPECTATIONS
FIG. 7 TIMING OF 1ST INTEREST RATE RISE*
% 2.0
% of forecasters
30
1.8
1.6
January 2016
25
1.4
1.2
February 2016
20
1.0
15
0.8
0.6
10
0.4
0.2
0
5
2014
2015
Inflation Reports:
2016
Aug15
2017
2018
Nov15
Source: Bank of England
Since the start of 2016, financial
markets have been particularly
turbulent on the back of
concerns about China and
emerging markets. Despite its
relative lack of exposure to these
areas, the UK has been caught
up in this sell-off, which has also
extended to much lower
expectations for future interest
rates. It now looks unlikely that
UK interest rates will rise before
mid-2017. But low interest rates
are encouraging strong lending
growth in some sectors, so the
Bank of England’s Financial
Policy Committee may soon be
forced to intervene.
icaew.com/ukeconomicforecast
2019
Feb16
0
Q1 2016
Q2 2016
Q3 2016
Source: Reuters survey of economists
Global financial markets have been
particularly turbulent since the
beginning of 2016, with the Dow
Jones Global Equity index falling by
7.3% in January alone. Nervousness
about China and other emerging
markets has been the main reason for
the collapse in confidence and, even
though it has relatively little exposure
to these markets, the UK has been
caught up in the sell-off, with the
FTSE All Share index declining by 4%
in January.
The market moves have not just
been confined to equities; market
expectations for future interest rates
have dropped significantly. At the
beginning of January, market pricing
implied that the first rise in UK interest
rates would come in the autumn of
2016, but by the time of the February
Inflation Report this had moved out to
summer 2018 and markets were also
Q4 2016
Q1 2017
*Surveys taken before MPC meetings
pricing a 25% chance of a rate cut in
2016. This move came despite a lack
of any hard evidence that the outlook
for the real economy had deteriorated
materially since the start of the year.
The expectations of financial
markets and economists have been
different for some time, with markets
consistently expecting the first rate
hike to come later. To some extent
this reflects the idea that they are
forecasting slightly different things;
economists tend to produce modal
forecasts, which depict the most
likely outcomes, whereas market
expectations are more of a mean
forecast, weighted according to
the spread of risks. Given that most
commentators agree that the risks to
economic growth are heavily skewed
to the downside, it is perhaps no
surprise that market expectations are
particularly dovish.
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Focus on: Will financial policy be tightened before monetary policy?
The February Inflation Report offered
the Monetary Policy Committee the
first opportunity to give its view of
how the outlook had changed since
the beginning of the year. While it
suggested that the outlook for both
GDP growth and inflation was a little
softer than it previously thought, due
to a combination of lower commodity
prices and the frustratingly slow
pickup in wage growth, it gave the
clear impression that it thought
that the recent market moves were
overdone and that the next move in
interest rates was more likely to be
up than down. The Bank’s forecast
suggested that wage growth was likely
to gradually accelerate over the next
couple of years, dragging inflation
back towards the 2% target by the
end of 2017. This forecast looked to
be consistent with a first rise in the
Bank Rate around the second quarter
of 2017, with gradual increases in the
region of 0.5% per year thereafter;
a little less aggressive than the
economists’ consensus, though still
well ahead of the market view.
Though the monetary policy
framework is centred on the outlook
for inflation, there are also broader
considerations for the Bank.
icaew.com/ukeconomicforecast
(continued)
Very low interest rates have provided
breathing space for the household
sector to restructure its balance
sheets, reducing the debt-to-income
ratio from close to 170% in 2008
to around 140% now. However,
there is evidence that some sectors,
most notably unsecured household
lending and buy-to-let mortgages, are
now starting to see relatively strong
lending growth at rates approaching
those seen before the financial crisis.
Very low levels of interest rates are
undoubtedly a factor behind this
strength.
This poses something of a dilemma for
the Bank, as clearly the case for raising
interest rates is weak for the economy
as a whole, particularly given the
strength of the headwinds coming
from fiscal policy. So the case for the
Bank to use its macroprudential tools
to intervene on a more targeted basis
is becoming increasingly compelling.
It has yet to make use of these recently
acquired powers and they would
represent something of a step into the
unknown. But the ability to deal with
specific problems, rather than using
the blunt tool of higher interest rates,
looks particularly attractive in the
current climate.
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