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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. 7 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. 8