The Middle East continues to dominate the headlines and the situation remains so fluid that meaningful comment is difficult. In the meantime, markets have also focused on the latest decision from the Bank of England, where the Monetary Policy Committee (“MPC”) voted 8:1 to leave interest rates unchanged at 3.75%. Although the margin was slightly larger than expected, markets had been widely anticipating this decision.
While the MPC has little influence over geopolitical events or external energy shocks, it has made it clear that it will respond to the higher oil prices and the inevitable impact this will have on inflation. In essence, if the price of oil falls and remains below $100 a barrel, the need for a rate rise is likely to recede and may be avoided altogether. However, if oil prices remain closer to $125 per barrel, at least one further rate rise is likely to be required.
There is a growing view that the current oil shock will be reasonably temporary and that the MPC should therefore look through the near-term impact rather than respond with higher interest rates. However, inflation has remained above target for several years and recent data suggests that inflation may rise further. Against that backdrop, a more pressing concern for the MPC may be maintaining its credibility in its fight against inflation.
Inflation expectations appear to be becoming de-anchored, meaning people are losing confidence that inflation will return to normal levels or remain under control, with many people expecting inflation to rise further and questioning whether the MPC is doing enough in response. Communication from the committee is therefore becoming increasingly important.
At present, it could be argued that money markets are effectively doing part of the MPC’s job for them. Yields have risen, while the MPC has made clear that it stands ready to raise rates further if necessary. Equally, if the oil prices fall, market rates are also likely to decline, meaning the MPC may not need to act at all.
What the committee will want to avoid is expectations of future MPC policy also becoming de-anchored. If markets begin to believe that inflation will continue to rise without a meaningful policy response, then interest rates will reflect market opinion rather than expectations of future MPC behaviour. Once markets stop listening to the MPC, restoring credibility becomes significantly more difficult.
The other side of the coin for the MPC is the outlook for economic growth. Current data remains reasonably encouraging, with the UK economy holding up relatively well. One development likely to please the MPC is that the household savings ratio remains comparatively high. This suggests that consumer spending may be able to withstand higher energy costs as households have scope to reduce savings to support consumption.
Another area that often attracts media attention is UK productivity. Historically, productivity growth in the UK economy averaged 2.5%. Currently, however, productivity growth is currently closer to 1.5%, often cited as evidence that the UK economy is not performing as efficiently as it could.
We were reminded last week that productivity figures should be considered alongside changes in the size of the workforce. With the UK workforce showing little growth, productivity of 1.5% is actually relatively encouraging. The greater concern would be a situation where the workforce is expanding at a greater rate than productivity, as this would imply that more people are producing proportionately less output.
All in all, the Bank of England is in a largely reactive phase. This could mean that UK interest rates are increased in the short term, before being reduced again once the current pressures and uncertainties begin to ease.
