SPECIAL FEATURE: MPC must follow Fed
Markets currently judge that U.K. interest rates will rise about six months after the first Fed hike. But the Bank of England seldom lagged this far behind in the past. Admittedly, the slowdown in the domestic economy that we expect will require the Monetary Policy Committee to be cautious. But wage and exchange rate pressures are likely to mean six months is the maximum period the MPC can wait before following the Fed’s lead.
Over the last month, overnight index swap markets have consistently expected the Fed to raise interest rates in mid-2016. Expectations for when the MPC will follow suit have been less stable, but investors now expect a hike in January 2017, six months after the Fed. In the past, however, the Bank of England usually has followed the Fed within a few months. Our chart above shows the gap in months between the start of U.S. and U.K. monetary policy cycles over the past 30 years. Only twice has the Bank waited longer than the markets expect this time around. The average lag has been five months, but it has clearly shortened since the Bank of England was granted independence in 1997. This might be because interest rates are now set purely on the basis of economic criteria, whereas previously they were subject to political influences too.
The MPC could make a case for waiting longer than usual this time since fiscal policy will be much more restrictive in the U.K. than in the U.S. The MPC also needs to be more sure than the Fed that higher interest rates are warranted, as the U.K. economy is more sensitive to short rates than the U.S. The household debt-to-income ratio is higher in Britain and most mortgages are linked to short rates.
The MPC’s scope to wait, however, has diminished as wage pressures have emerged faster than it anticipated, albeit after a longer than usual lag. U.K. wage growth is stronger than in the U.S., as our next chart shows. And upward pressure on U.K. wages is likely to intensify now that the unemployment rate has returned to its pre-recession level and firms are reporting increasing recruitment difficulties. Many firms will also have to raise salaries for over-25s in April to match the new National Living Wage, which is 7% above the current legal minimum.
A rebound in productivity growth could get the Bank off the hook, by limiting the impact of stronger wage growth on inflation, and we do see scope for better productivity performance over the medium-term. But with the fis cal squeeze intensifying and
exporters set to struggle, weak growth in demand is likely to prevent productivity growth matching its potential next year.
So far, the pick-up in wage growth has not pushed up core inflation, which was just 1% in the U.K. in September, well below the 1.9% U.S. rate. But this relative weakness largely reflects the fall in the price of imports, which comprise a higher share of consumption in Britain. By Easter, the drag from lower import prices will have unwound.
Meanwhile, if we are right to think that the U.S. will be compelled by a tightening labour market to raise interest rates this December, and to just under 2% by the end of 2016—earlier and further than markets currently expect—then the MPC won’t be able to sit on its hands for long. Sterling probably would fall sharply if the MPC raised rates just once in 2016, perhaps to about $1.30 from $1.52 currently, as the next chart of expected interest rate differentials and cable illustrates. The MPC won’t be able to tolerate such a large fall in the pound next year, since inflation is likely already to be near its target.
Accordingly, six months is probably the maximum period the MPC can wait after the Fed has hiked before higher wages and weaker sterling require a policy response. Interest rates won’t move in lockstep with those in the U.S., but we think the MP C will have to raise Bank Rate twice next year, once in Q2 and again in Q4, leaving it at 1% by the end of 2016.