Bank of England signals January rate cut
- Five members of the Bank of England’s Monetary Policy Committee have expressed dovish caution recently, suggesting a near-term easing would be appropriate if economic conditions weaken.
- November’s output data were weaker than expected suggesting economic stagnation in the fourth quarter, below previous forecasts. Inflation is also subdued for now.
- Uncertainty caused by previous awkward Bank communication and an expected pick-up in activity leaves doubts surrounding a cut. Several forecasters still expect policy to remain on hold throughout 2020, or at least until later in the year.
- Yet with rates close to the effective lower bound and the Monetary Policy Committee likely reviewing its assumptions around Brexit transition, we now think a 0.25% rate cut is most likely.
- We forecast one 0.25% rate cut in January, but then see policy on hold for the rest of the year. We forecast a global inspired softening in activity in 2021, which would result in additional easing next year.
Swift shift in policy outlook
After a year of political uncertainty and volatility in the UK, more recently it has been the economic outlook that has recorded sudden change. As Governor Carney approaches his last monetary policy meeting as Governor of the Bank of England (BoE) on 30 January, a rush of dovish communication from key members now points to further easing in monetary policy (Exhibit 1). Since November external members Michael Saunders and Jonathan Haskel have voted for a 0.25% reduction in the BoE’s key policy rate – the Bank Rate. We have argued that such Monetary Policy Committee (MPC) dissent has been a poor leading indicator for actual policy change. However, in the past week, Silvana Tenreyro, said she could vote “for a cut in rates in the near term” and Jan Vlieghe added that he needed to see “imminent and significant improvement… to justify waiting a little bit longer”.
While now all of the external members on the MPC have suggested dovish caution, their voices have also been joined by Governor Carney who last week said that “if evidence builds that the weakness in activity could persist, risk management considerations would favour a relatively prompt response”. This suggests an outright majority on the MPC, notwithstanding the unknown current views of other BoE officials on the Committee, that harbour doubts about the economic outlook.
Against that backdrop, economic output data for November disappointed. While we had been wise not to place too much faith in a persistent drop in construction output in October (this rebounded by 1.9% in November), this improvement was outweighed by a combination of a 1.7% monthly drop in manufacturing output (1.2% for industry as a whole) and a 0.3% decline in services output. In total, National Statistics estimated that this resulted in a 0.3% drop in monthly GDP in November. Notwithstanding modest upward revisions to September and October’s figures, the net effect is to reduce the outlook for the fourth quarter (Q4) GDP to 0.0-0.1%, by our estimates. This is weaker than the 0.2% that both we and the BoE had forecast earlier. Nor do we rule out the possibility of outright contraction in Q4 – which would be the second such quarterly drop in 2019.
Indeed, this provides a prima facie case for easier monetary policy. The Monetary Policy Report in November had warned that more stimulus may be required if downside risks materialised. A majority of MPC members have repeated their concerns for the outlook. Economic data has disappointed and inflation is currently below target – recording just 1.3% in December, its weakest in three years – and expected to remain so by the BoE over the coming quarters.
Why doubts linger
Despite this case for easier policy, a number of factors serve to make this an uncertain call – as evidenced by the number of other economists that still expect the MPC to leave policy on hold in 2020 – or at least envisage a rate cut only later in the year.
The first comes down to the BoE’s difficulty in communicating with markets in recent years. This has left the Governor with the unwelcome sobriquet of the “inconsistent boyfriend” – one aspect of his time as Governor he will be happy to leave behind. However, two years ago, in February 2018, the MPC began to build market expectations for a near term rate hike as it discussed policy tightening “somewhat sooner” than had been priced. It repeated this description up to and including the release of March’s minutes, prompting
the majority in markets to adjust forecasts expecting an impending rate hike at the next meeting in May. This the BoE then duly failed to deliver, actually only tightening in August – in line with our own ex ante expectations. Financial markets remember these communications missteps and are currently more cautious of interpreting the BoE’s comments.
We also expect recent economic weakness to prove volatile. In the short-term, the previous 31 March Brexit deadline resulted in sharp swings in output data – at that time reflecting swings in inventory. A similar effect should be expected around the 31 October deadline. Although the dip in activity this time has included the less inventory intensive services sector, some of November’s weakness is likely to short-lived. Moreover, the outlook for economic activity appears more generally to be improving. There are tentative signs of improvement in global trade conditions in East Asia, improvement which if continued should ease some of the global headwind that have dampened activity in the UK as well as across most developed economies. We also await significant fiscal easing in Chancellor Sajid Javid’s first Budget on 11 March. All of these factors suggest to us that quarterly growth is set to accelerate across 2020 and that Q4 2019 is likely to prove unrepresentative of growth over the coming quarters.
Indeed, our own growth forecasts envisage acceleration in UK quarterly growth to average 0.4% per quarter across 2020. This is despite the government to date squandering the prospect of a material improvement in business investment from reduced Brexit uncertainty by insisting that the UK will not extend the transition provision in the Withdrawal Agreement. This outlook for quarterly growth is in line with the BoE’s November outlook for 2020 (Exhibit 2). It was a key reason that we had expected the MPC to leave policy unchanged at 0.75% across 2020.
What lies beneath
Despite these lingering doubts, a number of more subtle arguments underpin our expectation for an easing in January, we think explaining the apparent shift in MPC outlook in recent weeks.
The Governor’s recent dovish caution came amidst a speech that concentrated on the limitations of monetary policy. While Governor Carney expressed a belief that the MPC has additional policy space for future policy accommodation (he estimates the equivalent of 250 basis points (bps) of Bank Rate reductions), he is clearly mindful of the broader limitations to central bank policy action as compared to history. A consequence of the BoE being closer to its effective lower bound in rates should be to make the MPC more cautious and more prone to pre-empting economic deceleration, erring on the side of easing too much, rather than too little. This suggests that the MPC may consider an “insurance” cut in the face of rising downside risks, even as it expects to see growth improve over the coming quarters. A similar motive has underpinned easing from both the Federal Reserve and European Central Bank (ECB) in 2019.
Moreover, the BoE’s growth projections for 2021 and 2022 were robust in November, forecasting 1.8% and 2.0% respectively. Our own outlook for 2021 is a more meagre 1.0%. We are cautious of a further deterioration in the global growth outlook into 2021 and it is possible that the BoE is also building in a more cautious global growth outlook in the wake of recent international tensions.
The MPC may also be more mindful of the political implications of its actions. The MPC’s robust GDP forecasts for the coming years were in part based on the assumption of a “smooth” Brexit transition. As current government policy at least questions that outlook, the MPC may also be prudently revising downs its longer-term growth outlook taking this into account. However, the MPC might find it more palatable to react to a short-term deterioration in actual economic data – no matter that it does not expect this to last – than to ease policy at a later date based on dwindling medium-term growth forecasts that reflect its assessment of how the government is conducting Brexit trade deal negotiations.
Indeed, such a consideration may be all the more pertinent given that January’s meeting marks Governor Carney’s last and that future meetings will be conducted by Governor-elect Andrew Bailey. The BoE may be keen to avoid some of the tensions between the new Governor and government, that have been a part of Governor Carney’s term. More broadly, this is also consistent with ECB President Draghi enacting policy change ahead of Christine Lagarde taking the helm at the ECB. Both new heads would be spared their first acts requiring easier policy, potentially colouring their reputations from the start.
One and done for 2020
For whatever combination of the above factors, the MPC appears to have clearly signalled a willingness to ease policy in the short-term if economic data disappoint. And economic data have disappointed. Admittedly, the coming weeks will deliver important employment data and January’s preliminary Purchasing Managers Indices (PMIs). We expect both to point to modest improvement. However, we doubt that the MPC will be swayed by predominantly backward-looking jobs data. Nor that it would place too much weight on the new preliminary estimates of the PMIs, which have been subject to revision in their first few months.
As such, we expect the MPC to ease Bank Rate by 0.25% to 0.50% at its January meeting. However, we continue to expect to see a quickening in economic growth over the coming quarters, consistent with returning the labour market to a tightening trend across 2020. We therefore characterise January’s move as an insurance cut in the face of some increase in downside risks, to the near-term and medium-term risks to the global outlook and plausible Brexit transition. At this stage, we do not think this is likely to be supplemented with additional easing this year, neither a final rate cut – and we continue to believe that 0.25% will prove to be the MPC’s effective lower bound for nominal policy – nor additional quantitative easing (QE). We forecast Bank rate now to close 2020 at 0.50%.
Looking further ahead, our medium-term outlook does include renewed global deceleration. Should this materialise, we would expect further easing ahead, in 2021 – likely both an additional rate cut and QE. However, if global growth can persist at moderate levels as we expect on balance for the bulk of this year, new Governor Bailey may spend much of his time – as Governor Carney has – considering the prospect of a “limited and gradual” withdrawal of stimulus over the medium term.
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