Bank of England: Economists split as monetary policymakers set out into the unknown | City A.M.
The Bank of England is widely expected to raise interest rates on Thursday, but the decision by the monetary policy committee (MPC) is likely to be one of the most controversial in recent memory. While most City observers now think rates will rise, economists are split as to whether hiking borrowing costs amid a weak economy – and shortly before the biggest political upheaval in 40 years – is the right course to take.
The Bank has already raised expectations of a hike once before, with clear signals that it would make a move in May. However, the hawkish rhetoric was undercut by a notably poor GDP reading for the first quarter of 0.1 per cent, prompting the MPC to hold fire.
That has since been revised upwards by the Office for National Statistics ONS (as expected by the Bank) to 0.2 per cent. Data for the whole second quarter are not yet available but data from the respected National Institute of Economic and Social Research predict growth of 0.4 per cent in the second quarter.
Read more: UK GDP growth recovers in May boost to Bank of England hawks
Economists at Nomura say the economy has staged something of a rebound from the first quarter – when the “Beast from the East” froze British economic activity – if recent data are to be believed. Citibank’s UK economic surprise index has held up in the past month, in contrast to the run-up to the May 2018 and August 2017 MPC meetings when it collapsed.
“The data haven’t suggested to avoid a rate hike,” says George Buckley, chief UK economist at Nomura. “Recent data on retail sales were down, but from the strongest quarter in 15 years”.
Meanwhile, closely followed purchasing managers’ index (PMI) data, based on large business surveys by IHS Markit, suggest that growth has held up across services, manufaturing and construction.
How tight is too tight?
One of the key reasons the Bank’s hawks want to raise interest rates is the historic tightness of the UK’s labour market. Unemployment remains at four-decade lows, while the employment rate, the proportion of all working-age adults in work, has hit its highest since records began, at 75.7 per cent.
“The main reason why you’d raise rates is the labour market,” says Simon French, chief economist at Panmure Gordon. Yet while headline measures appear to be “bulletproof” in supporting a hike, it is understandable that descriptions of a historically tight labour market are fiercely contested, he adds.
The outlier on the labour market has been earnings growth, which has generally lagged inflation for most of the past decade. In real terms, earnings have fallen by an average annual rate of 0.3 per cent since the financial crisis, leaving households squeezed.
Read more: Wages on downward trend in May to cast doubt on BoE rate rise prospects
Wages have not risen by anywhere near the extent predicted by the Bank in the years since the financial crisis. The Phillips curve, a touchstone for monetary policymakers, suggests that as unemployment falls, eventually wages will be pushed up as demand for workers rises. Yet Bank deputy governor Sir Jon Cunliffe this year admitted there have been “serial disappointments” on the pace of wage growth despite falling unemployment.
One possible explanation for the apparent failure is a mismeasurement of the amount of slack left to be taken up in the economy. Headline unemployment data is seen by some as a blunt measure which does not take into account “underemployment”, if people want to work more hours or would switch from self-employment to salaried work if given the chance.
Danny Blanchflower, a professor of economics at Dartmouth College and a former member of the MPC, will argue in an upcoming paper that UK unemployment could fall as low as 2.5 per cent before generating the wage increases which were standard before the crisis.
However, the decline in real wages has now started to reverse. Inflation has slowed as the impact of the collapse in the pound following the Brexit vote has all but passed through. Meanwhile, headline earnings growth has also improved a little, ranging between an annual rate of 2.5 per cent in May and as high as 2.8 per cent in March, giving four consecutive months of positive real earnings growth.
Last week’s announcement by the government that around a million public sector workers will receive their biggest pay rise in “almost 10 years” should add support to earnings growth going forward, according to economists.
Back to normality?
While arguments about the data rage, some critics of the Bank believe the UK should have raised rates far more aggressively in recent months in an effort to “normalise” monetary policy after a decade of massive stimulus to the economy.
At 0.5 per cent the current UK interest rate has been at emergency levels for a decade, although the UK economy is now more than 11 per cent bigger than before the start of the 2008-09 recession.
Andrew Sentance, a former MPC member who now advises KPMG on economics, says there has been a “strong case for some time for a gradual normalisation in monetary policy”. The case for a rate hike “doesn’t rest on short-term data”, he added.
Both critics and supporters of the Bank acknowledge that the constant stimulus from ultra-low rates and the giant programme of bond purchases known as quantitative easing have created distortions in the economy.
Bank chief economist Andy Haldane has suggested they may have helped to sustain poor-performing companies well beyond the point at which it would be sensible to wind up, effectively creating a class of “zombie” firms which are holding back productivity.
Another regular criticism of the Bank is that it is not following its mandate, essentially ignoring its target to return consumer price index (CPI) inflation to an annual rate of two per cent.
Headline inflation has been above the Bank’s target for 17 months, most recently sticking at 2.4 per cent in June.
Yet John Wraith, head of UK rates strategy and economics at UBS, is calling for rates to stay on hold. There is “not really a case for a rate hike, data are mixed at best, wages are not picking up”, he says. Core inflation, which excludes the volatile food and energy components which are vulnerable to influence from external factors, is also below target at 1.9 per cent and has been on a downward path since the start of the year.
Brexit risks
And then there is the elephant in the room: Brexit. The MPC insists it is data-focused, but there can be no doubt that the political and investment uncertainty facing the UK over the coming months will be a key issue in discussions.
Only eight months remain before the UK leaves the EU and the post-Brexit trading relationship remains uncertain. The ongoing lack of clarity is evident in recent surveys: data for July from the Confederation of British Industry (CBI) pointed to a significant deterioration in investment intentions among the UK’s manufacturers as firms batten down the hatches. Meanwhile, consumer confidence has also remained weak, with GfK’s index remaining in negative territory since 2016. Other data through June have not shown much in the way of improvement.
A month ago Carney told MPs on the Treasury Select Committee that there are potentially “big” consequences for the British economy if the UK leaves the EU without a deal. For some economists those risks remain too large to countenance raising borrowing costs. The Bank’s calculations say that Brexit has already cost British households £900 each; economists almost universally say that a chaotic Brexit would have a big negative effect on UK economic growth.
Whichever way the MPC turns, Carney and co. have repeatedly emphasised that they are ready to increase stimulus again if there is no deal or if the economy turns for the worst. Yet that will provide cold comfort for an MPC desperate to avoid a dreaded policy mistake. Whether advocating a hike or a hold, City economists are agreed that the Bank faces an unenviable task: setting monetary policy as the UK heads towards the unknown.