Economic policy advice all too frequently is couched in terms of “On the one hand, X, but on the other hand, Y,” and one-handed economists are in exceedingly short supply. For all the decisive action that the Bank of England has taken in the aftermath of the June 23rd European Union referendum, we suspect that ambidexterity may be reasserting itself in discussions between Monetary Policy Committee (MPC) members.
Let’s start with the “left hand” – the dovish implications of weaker growth forecasts. According to the MPC’s baseline forecasts, the outlook for the UK economy next year has deteriorated substantially in the wake of the EU referendum result. The projections in the August Inflation Report showed that UK monetary policymakers now expect Gross Domestic Product (GDP) growth in 2017 to be just 0.8 per cent, rather than the 2.3 per cent the MPC had been anticipating before the referendum result.
In particular, the MPC expects business investment in 2017 to be significantly weaker than hitherto anticipated (-2 per cent rather than +7¼ per cent), with firms more reluctant to invest in new infrastructure until there is greater clarity around the post-Brexit landscape. Thus, weak growth prospects allied to pre-existing slack in the economy presents a credible and coherent rationale for additional monetary stimulus, i.e. augmenting the case for even lower policy rates and more quantitative easing.
Now for the “right hand,” whose monetary policy implications are less accommodative. Not only have the recent economic data surprised on the upside, but the sharp depreciation in Sterling is pushing both inflation and, crucially, inflation expectations rapidly higher.
While the MPC might be inclined to “look through” (read, disregard) the expected jump in actual inflation – considering that to be a one-off shift in the price level – any significant drift in medium-term inflation expectations presents a more fundamental challenge to the credibility of an inflation targeting central bank, given its potentially self-fulfilling nature. So with the 5y5y forward breakeven rate of inflation on UK linkers having now risen to a 34-month high of 3.47 per cent (as of October 11), the MPC’s ability to ease policy further is now severely curtailed without risking exacerbating that inflationary drift.
Indeed, it is conceivable that the more hawkish members of the MPC could argue that should the de-anchoring continue for a sufficiently long period of time, the case for a credibility-enforcing rate hike could eventually coalesce.
Neither of those opposing views should be dismissed lightly, as both have a degree of merit. On balance, we suspect that the weight of opinion on the MPC is now probably inclined towards “wait and see” mode until such time as there is a decisive shift in either direction. Consequently, we expect no further adjustments in policy from the Bank of England over the next few months.
In our view the possibility of one final rate cut in 2017 should not be dismissed at this stage but, given the complex interplay of arguments on both sides, we suspect that would first require a moderation in inflation expectations and signs of a weakening in the macro data.
To give a simple, unambiguous, “one-handed” view of the policy landscape: based on current macro-financial conditions, we expect no further easing from the Bank of England this year.
James Ashley is head of international market strategy for strategic advisory solutions at Goldman Sachs Asset Management.