Blog Post

The Bank of England’s dovish hike

For the first time since 2007, the Bank of England raised interest rates, with a hike of 25 basis points. At the same time, it provided forward guidance that outlines a very gradual path for future increases. We review the economic blogosphere’s reaction to this decision.

By: Date: November 6, 2017 Topic: European Macroeconomics & Governance

Chris Giles at the FT says that the Bank has questions to answer: about its reasoning; about the UK’s economic prospects; and about the way it communicates the future outlook for interest rates. For most of this year, City economists have converged on the view that in light of Brexit, the Monetary Policy Committee (MPC) would not touch interest rates until late 2018 or even 2019. But hawkish MPC members appear to be in the majority and make three separate arguments that form a case for tighter monetary policy. First, the economy has not been as weak as the Bank predicted in August 2016. Second, the BoE has been saying since the EU referendum that the long-term consequence of the Brexit vote would be to reduce the potential rate at which the UK economy can grow without sparking inflation. It is a bold call to raise rates on the back of something that cannot be measured. Third is that some MPC members think the current level of interest rates is more stimulative than it was, so a rise is needed to prevent too much borrowing and spending. Insiders at the BoE think that communication of monetary policy is as important as the level of interest rates itself. The big question will be whether the MPC will follow a rate rise on Thursday with further tightening of monetary policy.

Tony Yates at Long and Variable would have voted against a rate rise for various reasons. First, it’s possible to read into the Inflation Report that a reason to begin hiking is a change of view about the pace of growth of future output. If this is the case, then this is not itself a motivation for tighter policy, unless for some reason the path of demand for a given policy is to be judged to have stayed where it was. But in the kind of models the BoE uses for forecasting, demand would be expected to be correspondingly muted. Second, the effect of Brexit on inflation via Sterling’s depreciation – expected as it is to be temporary, even if persistent – can be entirely discounted and the remit gives the MPC leeway to do that. Third, if we strip out the temporary effects of the Sterling depreciation, we go back to the old position that the MPC are hoping to return inflation from below, to target ‘in a sustainable manner’. This was code language for discounting concerns that at the zero bound, when uncertainty is heightened, the MPC should set policy so that the most likely outcome is to overshoot the target, and not to hit it. Fourth, the pivotal judgement seems to be that slack is being used up, judging from extremely low levels of unemployment. Yet this evidence is not as decisive as it first seems. Whole economy nominal earnings growth is flat at about 2%, and much lower than would be consistent with trend. Private sector earnings growth has increased, but over a very short period, and from a very low base.  The policy decision rests almost entirely on future growth materialising as a result of forces that take hold now and in the future.

Simon Wren-Lewis published few days ago a short guide to why the rates should not have been hiked. UK inflation is currently around 3% because of the Brexit depreciation, which is temporary. The key is to look at whether average earnings inflation is responding to higher consumer price inflation, and the answer is that they are not: average earnings growth has been slightly above 2% in 2017, which is a little lower than the average for 2016. As for unemployment being at an historical low, Wren-Lewis argues that unemployment is not currently a good measure of labour market slack and that it is quite wrong to assume we know what the level of labour market slack is that would lead to increases in earnings growth (ie the NAIRU). So why would the MPC raise rates? Wren-Lewis suspects the MPC is worried that Brexit has created a negative supply shock, as both investment and productivity growth are much lower than the Bank were expecting before Brexit. He argues that this reasoning indicates a conceptual weakness, because by choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, which the economy instead desperately needs right now. Additionally, after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but the UK is currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009.

Duncan Weldon argues on Prospect Magazine that a rise in rates once meant that the economy was returning to normal health, but not this time. Although inflation is high and unemployment low, growth is fairly tepid, real incomes are being squeezed and Brexit-related uncertainty is weighing on business investment decisions. The important point to grasp is that the Bank is not being driven into hiking by a renewed sense of confidence in the UK economic outlook. Indeed its most recent forecasts show growth around the 1.6 to 1.7 per cent mark for the next two years against a pre-crisis average of almost 3 per cent. The Bank has become more pessimistic on the medium term outlook at the same time as loudly signalling that it feels the need to tighten policy. This is a hike driven by pessimism not optimism, by despair rather than hope. For a decade British productivity has been stagnant, and growth has been driven by using up spare capacity, hence unemployment falling to 40 year lows despite an historically weak recovery. The problem with that growth model, is that at some point the output gap will close, and as that happens, inflation will pick up. The majority of Bank policy-makers now appear to think the UK has reached this point.

Wouter Sturkenboom writes on the Russell Investment blog that the BoE’s mixed move – a rate hike coupled with a dovish forward guidance on the gradual path for future hikes – was a close call with compelling arguments in favour and against. The arguments in favour of the interest rate hike start with the rise in inflation to 3% year-on-year, which is putting pressure on the BoE to tighten monetary policy. However, because the rise in inflation is mainly caused by a fall in the pound, it is not the main reason. More important for the BoE is the tight labour market, as unemployment rate is at its lowest level since 1975 and economic growth in the UK has held up better than expected since the Brexit vote. On the against side, concerns around inflation need to be tempered considering the transitory impact of a weaker pound, and although wage growth might indeed pick up in the future, as of late it has been rather sluggish, putting pressure on domestic consumption, which has been the engine of economic growth since the Brexit vote. Sturkenboom believes the risks are tilted on the downside, and argues that a one-and-done rate hike against such a dovish forward guidance background will only briefly impact markets, pushing down gilt yields and the pound and supporting equities.

Mike Amey at Pimco Blog says that inevitably there are questions that follow the first rate hike – particularly whether this will be a solitary move, or the start of an interest rate cycle. The MPC will not want this to be seen as a solitary rise, but at the same time will not want to unsettle markets by guiding expectations towards a quick succession of hikes. Amey thinks it was a sensible decision on the MPC side to damp speculation of the latter case by dropping the language about the market being too sanguine about the path of future rates. Amey believes that market expectations for a cumulative 0.5% of additional interest rate rises by mid-2020 looks low, and that the MPC would rather like to follow a path similar to that of the Federal Reserve, which has raised rates by a cumulative 0.75% since its initial hike in December 2015.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Powell's Federal Reserve

With the appointment of Jerome Powell as the next Fed’s chairman, President Trump break a tradition of bipartisan re-nomination and chooses someone who is not an economy by formation. We review economist’s opinions on this choice and the challenges ahead.

By: Silvia Merler Topic: Global Economics & Governance Date: November 13, 2017
Read article Download PDF

Policy Contribution

A ‘twin peaks’ vision for Europe

The organisation of the European Supervisory Authorities (ESAs) is based on a sectoral approach with one ESA for each sector, with separate authorities for banking, insurance and securities and markets. But is this sectoral approach still valid? This Policy Contribution outlines a long-term vision for the supervisory architecture in the European Union.

By: Dirk Schoenmaker and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: November 13, 2017
Read about event More on this topic

Upcoming Event

Dec
12
12:30

The impact of Brexit for Research & Innovation in Europe

This event will feature a new and interactive format, with a restricted and high-level on-site audience and in parallel, it will be livestreamed on our website to remain public and attract the widest participation

Speakers: Alastair Buchan, Matt Dann, David Earnshaw, Kurt Deketelaere, Maryline Fiaschi, Martin Muller, Christian Naczinsky and Reinhilde Veugelers Topic: Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Blog Post

European worries about isolationist trends

Populist shocks in the UK and US threaten the multilateral order on which the EU depends. What lies behind these earthquakes, and what does it mean for Europe? Withdrawing from the world is no solution to geo-political upheavals, but Europe needs to reassess the future of globalisation.

By: Maria Demertzis Topic: European Macroeconomics & Governance, Global Economics & Governance Date: November 7, 2017
Read article More on this topic More by this author

Blog Post

Falling Pound might not bring UK trade balance boost

The Pound Sterling depreciated by 14% against a basket of world currencies in the four months after the referendum vote to leave the EU. A number of pundits claimed that this would improve the UK trade balance and boost the economy. But the data do not show any visible improvement in the trade balance to date. Could it be that currency depreciations have less impact on trade balances than before?

By: Nicholas Branigan Topic: European Macroeconomics & Governance Date: October 31, 2017
Read article More on this topic More by this author

Blog Post

The capital tax cut debate

How much do workers gain from a capital gains tax cut? CEA chairman Hasset claims the tax cut will cause average household labour income to increase by between $4000 and $9000. Several commentators note this implies that more than 100% of the incidence of the tax is on labour. This question has triggered a heated discussion in the economic blogosphere, which we review here.

By: Silvia Merler Topic: Global Economics & Governance Date: October 30, 2017
Read article More on this topic More by this author

Blog Post

EU borders: walking backwards from Northern Ireland to Cyprus

The Good Friday agreement put to rest age-old conflicts on Ireland. It also offered hope that the reunification of Cyprus might be possible within the European Union. Lately, however, the “Green Line” that divides the easternmost island of the EU, is viewed as a template for a soft border at the westernmost island of the Union after Brexit.

By: Stavros Zenios Topic: European Macroeconomics & Governance Date: October 25, 2017
Read article More by this author

Blog Post

Bailout, bail-in and incentives

Ever since the outbreak of the global financial crisis, more and more rules have been developed to reduce the public cost of banking crises and increase the private sector’s share of the cost. We review some of the recent academic literature on bailout, bail-in and incentives.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 23, 2017
Read article More on this topic More by this author

Blog Post

An irrational choice: behavioural economist wins Nobel Prize

Richard Thaler was awarded this year's Nobel Prize in Economics for his contributions to the field of behavioural economics. His work documents a set of cognitive biases affecting economic decision-making and casts doubt on commonly-held assumptions about the rational ‘homo economicus’ that inhabits economic models and theories. What are the implications for the economics discipline and public policy?

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: October 16, 2017
Read article More on this topic More by this author

Blog Post

On the cost of gun ownership

On 1 October 2017, 59 people were killed and another 489 injured in what is currently the deadliest mass shooting in US modern history. The author reviews recent contributions on the economic cost of gun violence, as well as the impact of regulation.

By: Silvia Merler Topic: Global Economics & Governance Date: October 11, 2017
Read article

Blog Post

India’s trade ties with the UK and EU

As EU and Indian leaders meet in Delhi, we look at the figures on trade. The UK’s place in the relationship warrants special attention. EU-India trade has more than tripled since 2000, but UK-India trade is largely static. The shift is especially noticeable for EU exports to India, where the UK share has dropped from 29% to 10%.

By: Maria Demertzis and Alexander Roth Topic: European Macroeconomics & Governance, Global Economics & Governance Date: October 6, 2017
Read article More on this topic More by this author

Blog Post

The Economics of Healthcare

Healthcare reform has been a thorn in the side of the US administration for several months, prompting President Trump to declare that “Nobody knew that healthcare could be so complicated.” We review recent economists’ views on the issue.

By: Silvia Merler Topic: Global Economics & Governance Date: October 2, 2017
Load more posts