September Interest Rate Decision

What a difference six weeks makes. When the Bank of England published its last Quarterly Inflation Report (QIR) at the beginning of August, it showed market expectations were that base rate would not return to 0.5% until late in 2018. At the time, the Bank’s press release warned that “…if the economy follows a path broadly consistent with the August central projection, then monetary policy could need to be tightened by a somewhat greater extent over the forecast period than the path implied by the yield curve underlying the August projections.”

The markets chose to ignore the Old Lady’s hint that they were being too optimistic about rates remaining unchanged. There were good reasons for the markets to be sanguine. The Bank has a track record in recent years of making noises about rate rises that never become reality – hence the Governor being described as “an unreliable boyfriend” by a member of the Treasury Select Committee in summer 2014. Similarly, for all the threat of rates rising faster, at the August meeting only two of the then eight Monetary Policy Committee (MPC) members – both independents – voted for a rate increase.

Thursday’s meeting of the MPC was expected to be another steady-as-she-goes non-event, complete with a further (ignorable) suggestion that rates might rise sooner than the markets thought. In the event, the MPC took a much more robust stance, which surprised the market to the extent that the FTSE dropped over 1% while the pound bounced up about two cents against the dollar and over a cent against the euro. To see why, it is worth looking at some of the detail in the Bank’s latest press release:

• “Overall, the latest indicators are consistent with UK demand growing a little in excess of this diminished rate of potential supply growth, and the continued erosion of what is now a fairly limited degree of spare capacity. Underlying pay growth has shown some signs of recovery, albeit remaining modest.” Translated from Bankspeak, that means that slack in the economy is being taken up and wage pressures are starting to emerge.

• “Headline and core CPI inflation in August were slightly higher than anticipated. Twelve-month CPI inflation rose to 2.9% and is now expected to rise to above 3% in October.” The August QIR implied that the Bank did not expect inflation to reach 3%, but the 0.3% jump in the August inflation rate makes a 3%+ rate look more likely for September. Mr Carney will then be forced to write an explanatory letter to the Chancellor.

• “Recent developments suggest that remaining spare capacity in the economy is being absorbed a little more rapidly than expected at the time of the August Report, and that inflation remains likely to overshoot the 2% target over the next three years.” The timeframe here is significant as the Bank would normally look to have inflation around its 2% target level at the end of two years.

• “The Committee judges that, given the assumptions underlying its projections … some tightening of monetary policy would be required to achieve a sustainable return of inflation to the target. Specifically, if the economy follows a path broadly consistent with the August central projection, then monetary policy could need to be tightened by a somewhat greater extent over the forecast period than the path implied by the yield curve underlying the August projections.” This is a repeat of the August nudge to the markets to remove the rose-tinted glasses.

• “All members agreed that any increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.” This is also a repetition of a common Bank statement: when rates rise, it will not be a 0.25% per meeting exercise, but a very gradual process.

By the end of Thursday, the money markets had put the chance of a rate rise by November at about 50%, with virtual certainty of a 0.5% rate by February 2018. Gilt prices fell (and thus yields rose) to reflect the new expectations. In one sense, the MPC had obtained the benefits of a rate rise – higher yields, stronger sterling – without having to unwind the 0.25% Brexit-inspired cut made in August 2016. All eyes will now be on 2 November, the next “Super Thursday”, when the Autumn QIR, MPC rate decision and MPC minutes are all published.