Today the Bank of England’s (BoE) Monetary Policy Committee met, and decided unanimously to keep interest rates on hold at 0.75%.
This was in-line with market expectations and so there was limited impact on UK markets. While rates remained on hold today, the reducing levels of slack in the economy suggest that pressure continues to increase on the BoE to raise its key policy rate.
In our view the Bank of England should deliver a modest tightening of policy this year. The economy is clearly at full capacity and inflationary pressures are building. The labour market continues to surpass expectations and set new records – employment is at an all-time high, unemployment sits at a 44-year low and wages are increasing at their fastest pace since the Global Financial Crisis. UK unit labour costs are now rising at 3.1% year on year. The latest BoE forecasts indeed show that growth is set to remain well supported, and inflation continue to increase, reaching above the target level at the end of the forecast horizon (see Exhibit 1).
Exhibit 1: Bank of England forecasts
Source: Bank of England, J.P. Morgan Asset Management.y/y is year on year. Data as of 2 May 2019.
Brexit uncertainty has been the main factor preventing the Bank from responding to rising inflationary pressures. While uncertainty remains, the risk of the most adverse scenario – no-deal – has receded considerably. Recent weeks have demonstrated there is very little appetite for such an outcome in either UK or EU political circles.
The Bank will however find itself swimming against the tide of policy elsewhere given the recent dovish pivot from the US Federal Reserve and European Central Bank. A global manufacturing and trade malaise has emerged, likely caused by weakness in Chinese demand and ongoing global trade tensions. But our base case for this year is that growth will stabilise at roughly trend rates in the US and Eurozone. There are signs of this stabilisation in the recent data.
In summary, no-deal risk is subsiding, and along with it the most adverse scenarios for the UK economy. It also seems highly likely given the recent improvement in the public finances that there will in the Autumn be a boost from fiscal policy, which will push the UK further above capacity. The Bank of England should take this opportunity to modestly normalise interest rates from their current very low level.