Turning a blind eye to inflation (again)
9 February 2017
In the immediate aftermath of last June’s vote to leave the EU, the Bank of England’s Monetary Policy Committee
took just six weeks to deliver a wide-ranging package of monetary stimulus, including a cut in the Bank Rate to
just 0.25%. Six months on and the economy has proved to be unexpectedly resilient and the Bank of England
anticipates that the annual rate of consumer price inflation will be higher than the 2% target for at least three
years. So why isn’t the MPC champing at the bit to raise interest rates?
The start of this month brought another so-called ‘super Thursday’ on 3rd February, when the Bank of England
not only announced the decision of its monetary policy deliberations but also released its quarterly Inflation Report .
This document, and the associated press conference, provides the most detailed insight into the MPC’s thinking
and so offers the best clues as to whether any changes to the stance of monetary policy are imminent.
This latest ‘super Thursday’ was of particular interest in light of the economy’s surprising resilience since the EU
referendum and the near-certainty that the annual rate of consumer price inflation is about to exceed the 2% target,
set by the Chancellor of the Exchequer, for the first time since November 2013. More to the point, it is expected
to remain above the target for some considerable time. This conjunction of circumstances had led many investors
and analysts to believe that Bank Rate might be about to rise: the implied probability (based on money market
interest rates) of an increase by the end of this year got as high as 50% in recent weeks, and was still at around
44% before the release of the Inflation Report on 3rd February.
The bar for monetary tightening is set high
Here at HSBC, we have not changed our view that a rate rise this year is unlikely. It’s plain from Bank of England
statements going back several years that the bar for tightening monetary policy is set very high. Had the MPC
really wanted to escape from the weird world of near-zero interest rates there were occasions in 2011 and 2014
when it could reasonably have taken action; and indeed, on both occasions a few members of the Committee
did break ranks with the ‘do nothing’ consensus.
This latest Inflation Report showed that the MPC’s dove-ish mindset remains intact. By the time Mark Carney
had finished his press conference the implied probability of a rate hike this year had fallen back to around 33%.
The minutes of the MPC meeting, which wrapped up on 2nd February, affirmed the willingness of the Committee
to ‘look through’ the imminent period of above-target inflation. This was explained partly (and very predictably)
on the grounds of ongoing Brexit uncertainties, but also by a re-assessment of the economy’s supply potential.
The Bank of England undertakes an appraisal of the capacity of the economy every year. To say that it’s
not an exact science would be an understatement, and the Inflation Report readily admits this. The only safe
assumption is that if there is an absence of domestically-generated inflation then the economy has sufficient
capacity. According to the previous assessment, the equilibrium rate of unemployment, i.e. that consistent with
an economy utilising all its resources, was 5.0%. Given that the unemployment rate has been below this level
for many months with no obvious build-up of inflationary pressures, it was hardly a surprise that they trimmed
the assessment of the equilibrium rate down to 4.5%. More to the point, the forecasts contained in the Inflation
Report don’t expect the rate of unemployment to fall any lower than the current level of 4.8%, which suggests
that the MPC feel fairly relaxed that the economy isn’t going to be pushing up against any supply constraints
in the next few years.
A stronger growth forecast for 2017
With the economy reckoned to have more capacity than was previously believed, the MPC was able to raise its
forecasts for economic growth while barely changing its previous inflation forecasts. Having been widely criticised
for offering a fairly bleak assessment of the country’s prospects just before, and immediately after, last year’s
EU referendum, it has made a volte-face to become one of the more optimistic forecasters. Last August, they
expected that growth in 2017 would be an anaemic 0.8%: now they think it will come in at 2.0%; in other words
virtually unchanged from 2016. They still think that a modest slowing will take hold later this year, with GDP slated
to expand by around 1.5% in both 2018 and 2019.
The judgement about the economy’s capacity is pivotal: if the MPC is right about growth but wrong about the
supply potential, then it will land itself with a difficult policy conundrum, just as the country is facing the uncertainties
of disentangling itself from the EU. Their latest forecasts anticipate that the rate of consumer price inflation
will peak at 2.8% in the early months of 2018. The rate is then expected to fall back but only at a gradual pace,
so that inflation is not projected to get back to the target of 2.0% until 2020.
The MPC has always been prepared to tolerate periods of above-target inflation when they blow in from abroad in
the form of currency depreciation or spikes in commodity prices: recall that no action was taken when inflation was
above target for a full four years from 2010 to 2013. But while they appear content to ‘look through’ an extended
period of slightly above-target inflation, the minutes of the recent policy meeting showed that some members of
the Committee felt that this was close to what they could tolerate without raising Bank Rate. A few days after the
publication of the Inflation Report , one member of the Committee, Kristin Forbes, broke cover by saying in a speech
that she believed interest rates would need to rise if the economy continued to expand at its present robust pace.
How high will inflation go?
HSBC’s view is that inflation will spike rather higher than the MPC expects, with the annual rate of consumer price
inflation topping out at 3.7% at the end of this year. (Though, for the reasons discussed below, we believe that the
MPC will be saved from having to act by a weaker growth environment.) Our inflation forecast is driven partly by
the continued ‘pass-through’ of earlier falls in the pound but also by our view that sterling will fall further, ending the
year at an exchange rate of $1.10 against the US dollar. Even if the pound doesn’t fare quite so badly, there will be
a fresh impetus to inflation in the form of rising commodity prices. In particular, last November’s OPEC agreement
(which included some major non-OPEC producers) to curb oil production has lifted oil prices, with Brent crude
Upgrading the growth forecasts for 2017
Source: Bank of England, HSBC
having risen by around $10 a barrel: this is starting to be reflected in petrol prices and utility costs, and will
eventually feed through into a wider range of consumer goods and services. There may also be a short-lived
upward inflationary impulse from the recent spell of unusually cold weather in southern Europe, which has hit
supplies of fruit and vegetables.
Are consumers starting to feel the pinch?
Not only will the rate of inflation break through the 2% target in the next month or two, but it will soon close the
gap on the rate of earnings growth. It’s been the solid gains in real wages (the difference between earnings growth
and inflation) which has driven the UK’s robust economic growth of the past three years. With the government
still tightening the fiscal screw, and with businesses wary about committing to capital spending amid the Brexit
uncertainties, any loss of momentum in the household sector is almost certain to slow the economy’s growth rate.
So, unlike the Bank of England, we expect a noticeable slowdown to take hold in the coming months, with the
growth rate for the whole of this year coming in at a modest 1.2%.
The past few weeks have brought tentative signs that the near-boom conditions that have prevailed in the consumer
sector are starting to fade, although it’s still much too early to reach firm conclusions. The official measure of the
volume of retail sales, published by the Office for National Statistics (ONS) registered a surprise monthly decline
of 2% in December. This was sufficient to trim the quarterly growth rate (which compares the volume of sales
in the latest three months with the preceding three months to 1.4%, from 2.1% in November. But data on retail
sales are notoriously volatile and prone to all sorts of statistical factors, and it’s important not to leap to premature
judgements. Early evidence about January’s trading from the British Retail Consortium is indicative of another quiet
month, but only if this is confirmed in the official data, due out on 17th February, could we start to talk about the start
of a consumer slowdown.
A good start to 2017 for the business sector
In terms of business activity as a whole, the first crop of this year’s Purchasing Managers’ Index (PMI) surveys
point to a brisk start to 2017. The composite output measure, which combines the results from the manufacturing,
construction, and services surveys, fell back by 1.2 points compared with December. But January’s reading of 55.5
was still stronger than the readings for ten of the 12 months during 2016, and if maintained would be consistent
with GDP growth in the first quarter of 0.5-0.6%. The stand-out feature of the PMI surveys for January was the
responses to the questions about input and output prices. Because the PMI results are reported as balances
(in essence, the difference between the number of respondents answering ‘up’ and ‘down’), it isn’t possible to
Has the retail sales boom run its course?
This economic briefing is issued by HSBC Bank plc (“HSBC Bank”) for information purposes only. It is not intended to
constitute investment advice, and no liability can be accepted by HSBC for recipients acting independently on the contents.
The information presented here is based on sources believed to be reliable, but HSBC Bank accepts no liability for any
errors or omissions. Unless otherwise stated, any views, forecasts, or estimates are those of HSBC Bank, which are subject
to change without notice.
Issued by HSBC Bank plc
HSBC Bank plc, Business Economics, 8 Canada Square, London E14 5HQ HSBC Bank plc 2017 All rights reserved
translate the results into percentage changes. Nonetheless, it is clear that inflationary pressures are building,
with the composite measure of output prices now at its highest since April 2011. On that occasion, consumer
price inflation ended up peaking at 5.2% in September of that year. There is especially strong pressure on
manufacturers, where the latest PMI survey reported the strongest reading for input prices since the survey
began in 1992.
Pressure is building in the inflation pipeline
Source: Markit PMI surveys
Will the MPC continue to turn a blind eye?
So although the MPC has in the past been prepared to turn a blind eye to periods of above-target inflation,
and although our ‘main-case’ scenario is that there will be no rise in Bank Rate this year, the chances of a rate
rise are not negligible. Inflation is on the march and economic growth remains resilient. What will matter in the
months ahead is what happens to sterling, and the extent to which a lower pound and rising commodity prices
translate into price increases for consumers. The other key consideration is whether workers are able to bid
up their wages to keep pace with rising prices: the annual rate of pay growth is currently running at 2.7% and
has been edging higher in recent months; should this figure break above 3% against a backdrop of still-robust
growth, then members of the MPC may start to feel that they have little choice but to take action.
Head of Economics, UK Commercial Banking
HSBC Bank PLC