Turning a blind eye to inflation (again)

Economic commentary

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.

Economic commentary

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

Economic commentary

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?

Source: ONS

Economic commentary

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

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.

Mark Berrisford-Smith

Head of Economics, UK Commercial Banking

HSBC Bank PLC