All major central banks now face a similar dilemma, but the challenge for the Bank of England is harder than most. The failure of wages to rise despite falling unemployment, a puzzle common to all advanced economies, makes it hard to know when interest-rate increases might be needed to offset inflation. But in the U.K., that assessment is made more complicated by Brexit.
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Much of the world is enjoying the first synchronized upswing since the start of the global financial crisis 10 years ago, but U.K. growth is slowing. The economy expanded by 0.2% and 0.3% in the first two quarters. That is just half the rate of the buoyant eurozone, and it forced the BOE last week to cut its forecast for growth this year by 0.2 percentage points to 1.6%.
The BOE's downbeat assessment of the impact of Brexit uncertainty -- and the lack of guidance on the timing of a rate increase -- triggered a swift market reaction: Sterling fell 0.6%, and the gilt yield curve flattened. In the space of a few weeks -- and despite inflation at 2.6%, well above the BOE's 2% target and forecast to stay above target for the rest of its three-year forecasting horizon -- speculation that the BOE might be the next central bank to raise interest rates has given way to a belief it will be the last. But was the market right to react this way?
The BOE clearly thinks not. The market is expecting two rate increases by 2020. But bank governor Mark Carney warned at last week's Inflation Report press conference that the BOE's rate-setting committee believes that if the economy continues to grow in line with its revised forecasts, further rate increases will be necessary. Its concern isn't just that Brexit is hitting demand as the higher inflation resulting from the 18% trade-weighted devaluation of sterling since its pre-referendum peak eats into household incomes and business uncertainty holds back investment, but that Brexit is hitting supply too. Under the BOE's latest forecast, corporate investment is expected to be 20% lower in 2020 than it was predicting before last year's referendum.
To be fair, the U.K.'s supply-side challenges predate Brexit. Productivity is 18% below where the BOE might have expected it to be if it had maintained its precrisis trend. Evidence suggests, however, that Brexit is making the problem worse. Businesses are delaying building the new capacity needed to build the U.K.'s capital stock to cope with improving global conditions and boost productivity. As result, the BOE has lowered its estimate of U.K. potential growth -- the rate at which it can grow without generating inflation -- from around 2.5% precrisis to 1.75% now. If Brexit leads to reduced immigration and creates new obstacles to trade with the European Union, it could yet further lower what Mr. Carney calls the U.K.'s "speed limit".
So why did the market ignore the BOE's warnings, causing the yield curve to flatten rather than steepen?
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It may be that the market has seen through the BOE's attempts to "talk hawkish and act dovish." After all, three members of the BOE's rate-setting committee voted in favor of a rate increase in July and a fourth, BOE chief economist Andrew Haldane, hinted he might soon join them. Yet last week, only two members voted to raise rates. That was a signal to markets that the first rate increase may in fact be further away than seemed likely a month ago.
A second reason could be that the market thinks the BOE is underestimating the Brexit hit to the economy. The BOE's own central scenario is based on the most optimistic outcome for Brexit, including a smooth transition to a new trading arrangement that preserves a large degree of access to the EU market. But Credit Suisse, for example, expects the U.K. economy to grow by only 1.5% this year, 0.2 percentage points below the BOE's revised forecast, reflecting its view that business investment and net trade will be even weaker than the BOE is predicting. Meanwhile housing market activity is slowing, new car sales have fallen for four months in a row and the BOE is putting pressure on banks to rein in riskier consumer lending, further dampening household spending.
A third reason may be that the flatness of the yield curve reflects the market's assessment of the risk that the U.K. and EU will fail to reach any negotiated exit deal. Indeed, some banks believe the probability of this extreme scenario is as high as 25%. Investors may be betting that this would deliver such a hit to growth that the BOE would have to loosen monetary policy. Yet a no-deal Brexit would not only do even greater damage to the U.K.'s supply side potential, it would also likely lead to further erosion in sterling, driving inflation further above target, while creating a hole in the public finances that the government probably would aim to fill with increased borrowing, raising doubts about its fiscal credibility. Under such a scenario, the BOE might have little choice but to raise rates.
As the BOE grapples with its Brexit dilemma, the market should brace itself for surprises.
Write to Simon Nixon at email@example.com
(END) Dow Jones Newswires
August 06, 2017 12:23 ET (16:23 GMT)