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Heteronomics Boe Preview: Hiking Cycle but Not Heteronomics 28 July 2017 BoE preview: hiking cycle but not yet H1 GDP growth has disappointed by enough to leave live concerns about how weak • Philip Rush the economy currently is, which should encourage the MPC to leave Bank rate on +44 (0)7515 730675 hold in August. I expect two dissenters, with the new member joining the majority. +44 (0)2037 534656 • Falling unemployment is indicating a persistent and significant supply shock, [email protected] which is inherently inflationary and hawkish. I continue to expect the MPC to start raising Bank rate in May-18, with risks skewed earlier. • Most members may expect to hike sooner, but there is no need to commit. By clarifying that a rate increase would probably be the start of a slow cycle, the curve could steepen, strengthening Sterling, and easing the policy trade-off. That would buy time without risking a loss of credibility by failing to hike on schedule. At 12:00 BST on 3 August, the BoE will publish its latest Inflation Report along with its decision and minutes to the meeting. Since its last report on 11 May, there have been lots of surprise falls, including in unemployment, wage growth, GDP tracking estimates, Sterling, and the oil price (Figure 1). Naturally, the implications of those things are more varied, especially amid differently dated releases. At the BoE’s 15 June meeting, it turned surprisingly hawkish, with Ian McCafferty and Michael Saunders joining Kristin Forbes in voting for an immediate rate hike. The unemployment rate had fallen below the BoE’s forecast while inflation was overshooting, with the outlook stronger still amid Sterling devaluation. The trade-off between slack and inflation had become intolerably skewed for them. Hawkish commentary from other members, most notably Andy Haldane, caused me to pull forward my BoE call to May-18 (see BoE: hiking rates early). Most of the disappointments have come since then, including inflation unwinding some strength, although another fall in unemployment to 4.5% was a significant exception. The latest disappointment to the BoE’s forecast was the sluggish GDP growth of 0.3% q-o-q in Q2. That was only 0.1pp below the May forecast, but the downward revision to Q1 means the ONS estimates H1 growth at nearly half the projected pace pencilled in by the BoE (Figure 2). The pickup in Q2 provides some reassurance that the economy is not sliding down a dark path, but it is hardly compelling enough to dispel lingering concerns (see FLASH: GDP suffering from supply shock). It appears Q1 was not entirely a spurious blip. Figure 1. Summary of news since previous Inflation Report Figure 2. GDP growth forecasts Forecast Outcome Surprise %, q-o-q 0.8 BoE: May-17 Economics (pp) 0.7 BoE: Feb-17 Q2 GDP growth 0.4 0.3 -0.10 0.6 BoE: Nov-16 Q2 unemployment 4.7 4.5 -0.2 0.5 Q2 CPI inflation 2.7 2.7 0.08 0.4 Markets (%) 0.3 ONS 1st Q2 ONS 1st Q1 0.2 estimate Sterling TWI 78.9 77.0 -2.4 estimate Oil prices, £ 41.3 37.4 -9.4 0.1 ONS 2nd Q1 estimate FTSE allshare 3970 4049 2.0 0.0 (pp) Gilt 5yr 0.51 0.64 0.13 Source: Reuters, BoE, ONS and Heteronomics. Source: BoE, ONS and Heteronomics. 1 Heteronomics | Bank of England 28 July 2017 Assuming, as I do, that the economy has stabilised, concerns about the downside scenario should gradually diminish as data are released. However, I neither expect a resurgence back to the brisk pace of growth in 2016 or see that as necessary for the BoE to deliver a rate hike. Softness in the economy is looking increasingly like a negative (productivity) supply shock, and that is inflationary and hawkish for monetary policy. Had the H1 slow down been a demand shock, employment should also have disappointed. Using the Okun’s law relationship implied by the BoE’s forecasts, the 0.3pp shortfall should have added 0.1-0.2pp to the unemployment rate (Figure 3), and yet it fell by another 0.2pp instead. Taking GDP weakness at face value as a demand shock and the differential behaviour of unemployment as a supply shock reveals a worrying trend. A third consecutive negative supply shock appears to have occurred this quarter, with the latest one larger than most other historical ones. The demand shock is small in comparison (Figure 4). Figure 3. Okun’s law in BoE forecasts Figure 4. Indicative model shocks at Inflation Reports 0.8 2.0 0.6 y = -0.4399x + 0.8344 1.5 R² = 0.9171 0.4 1.0 0.2 Feb-17 0.5 0.0 -0.2 0.0 1.0 2.0 3.0 4.0 5.0 0.0 May-17 Standard deviations -0.4 -0.5 Apr-14 Apr-15 Apr-16 Apr-17 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Dec-14 Dec-15 Dec-16 -0.6 -1.0 Dec-13 4Q forecast change in in UR, 1Qf change 4Q forecast -0.8 -1.5 -1.0 -2.0 -1.2 Demand Supply GBP GDP growth forecast, 4Q forward -2.5 Source: BoE and Heteronomics. Source: Heteronomics. Using these (and other) identified shocks alongside the impulse response functions from the BoE model indicates that the upside inflation news should dominate the BoE’s forecast update (Figure 5), not least because of an abrupt turn back toward Sterling weakness. It was strength in Sterling that had driven the dovish downgrades to the BoE’s inflation forecasts in the previous two reports. Acting against this inflationary force in the headline projections (conditioned on market interest rates) is the rise in yields over the past few months. The U9 short sterling contract has sold off about 15bp between the periods used for the BoE’s assumption. Given the strong relationship between changes in rates and inflation in two years, that difference should subtract about 8bp from the CPI inflation forecast two years ahead. This pressure seems small in comparison to the upside inflationary news, so I expect the BoE to present slightly higher inflation forecasts through the medium- term. That would send a message that the market still isn’t pricing in enough tightening. Figure 5. Mechanical top-down inflation forecast news Figure 6. Market rate adjustment pp, y-o-y Difference in inflation rate (2yr ahead) 0.4 0.6 Mervyn King 0.4 Mark Carney 0.3 May-17 0.2 Aug-17 0.2 0.0 -0.2 y = -0.25x R² = 0.90 0.1 -0.4 -0.6 0.0 -0.8 y = -0.52x -0.1 -1.0 R² = 0.91 -1 0 1 2 3 4 Demand Supply Inflation GBP Credit Energy Difference in conditioning rate (2yr ahead) -0.2 Source: BoE and Heteronomics. Source: BoE and Heteronomics. 2 Heteronomics | Bank of England 28 July 2017 Although these forecast changes would be hawkish relative to the May Inflation Report, it is not all news relative to June, so we should not extend a hawkish trend from that the June meeting. The main marginal hawkish development is the fall in the unemployment rate to 4.5%, which is in line with the BoE’s only recently lowered estimate of the NAIRU. The previous fall to 4.6% had also been a significant driver of the last hawkish step. However, whereas decent data accompanied the previous fall, the latest one has been surrounded by weakness elsewhere. An inconsistent picture raises uncertainty and makes it harder to clear the evidential hurdle needed to justify a policy response. There are costs to making a mistake. Moreover, the new MPC member has previously expressed doubts about the relative power of looser monetary policy, which should encourage patience in the policy response (see BoE: Silvana Tenreyro has some dovish form). Reversing a hike does not reverse the full economic effect. For the two remaining hawks on the committee, there is little need to retract their dissents. Doing so would be inconsistent with their expressed preferences for dealing with the current trade-off between spare capacity and inflation, which has only got worse. On the other side, the majority should be discouraged from hiking by the disappointing news elsewhere, which leaves a bigger question mark hanging over critical areas. Mark Carney expressed a preference to see how the data will develop in the months ahead, probably because he wants clarity on issues like the longevity of the GDP soft patch and dip in wages. It’s still a case of months rather than years, though, in my view. The BoE could also do a mini-supply stocktake exercise (they are usually annual, with the last one occurring in Feb-17) and find some slack that saves the policy trade-off from becoming intolerable. The two-year forward trade-off should remain within the preferred “lambda cone” (Figure 7). The three-year forward is probably outside that, hence the hawkish commentary, but uncertainty and the risk of error means there is tolerance around that cone before responding (Figure 8). Figure 7. BoE 2yr forward trade-off from its own estimates Figure 8. The 3-dimensional policy trade-off Y: Inflation Z: policy error intolerance Policymaker’s preferred trade-off zone Old? X: Output gap Source: BoE. Source: Heteronomics. In June, the MPC was probably warming up for a November hike, and it will likely want to leave that open as an option but without making any commitment.
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