The Bank of England: How to Justify Doing Nothing

by Mike Amey of PIMCO, 2/3/17

Ahead of Thursday’s quarterly Inflation Report, the Bank of England’s Monetary Policy Committee (MPC) faced a relatively tricky challenge. How can it justify doing nothing – holding interest rates steady and offering no strong view on the direction of monetary policy – while also increasing its growth forecasts, at a time when it already expects inflation to overshoot the target for the next three years?

As it turns out, the answer is relatively simple – adjust labour market modeling such that you can forecast structurally lower levels of unemployment and very benign (limited) wage growth. In effect, raise the forecasts for both demand and supply. But if it is indeed that simple, what are the risks around this forecast, and what are the implications for UK assets?

Macro uncertainties

The BOE now forecasts UK GDP growth of 2% this year before falling back to 1.6% in 2018 and 1.7% in 2019, while it expects Consumer Price Inflation (CPI) to peak at around 2.8% early in 2018 and decline only gradually to 2.4% by the start of 2020. Compared with our own forecasts, the BOE is more optimistic on growth but more pessimistic on inflation (we see CPI falling back toward the 2% target by early 2019). So given the relatively good growth backdrop and expectations for a persistent inflation overshoot, some might ask why the MPC isn’t offering a stronger view on the likely direction of monetary policy.

The answer seems to lie in major uncertainties about how the economy will evolve, both domestically and globally. In terms of local dynamics, the biggest question marks relate to consumer spending and wage growth. In particular, how will UK consumers respond to the rise in inflation, and will employees be in a position to demand higher wages? We agree with the BOE’s assessment that household spending will slow if real incomes get squeezed and workers are not able to demand wage increases to compensate for the rise in inflation. If that transpires, then we think the BOE is right to hold back from tightening policy.

Implications for UK assets

The BOE’s current policy stance suggests that the inflation risk premium in UK assets should be elevated – in terms of both the steepness of the nominal yield curve and the breakeven inflation rate. Given a higher inflation risk premium, it also suggests that UK yields would underperform those of other global bond markets, such as the U.S., and that the British pound would remain under pressure. Even if the BOE is right to expect the rise in inflation to be transitory, that should not stop markets from embedding a higher risk premium on UK assets.

Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.

The Bank of England: How to Justify Doing Nothing

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