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On Thursday the markets were taken by surprise when the Bank of England (BoE) did not reduce interest rates...they shouldn’t have been.
Having failed to increase interest rates over the last 12 months when the economy was producing robust economic data, the BoE has no choice but to use its limited firepower prudently. Whilst the little data available would certainly suggest a weakening economy, comments by BoE Chief Economist Andy Haldane suggest the BoE favoured delaying any decision until August when more data will be available, even though truly representative data is unlikely until October.
What should be clear to policy makers is that any response to a slowdown must be robust and multi-dimensional and cannot be solely driven by further monetary easing. Importantly, the collapse of investment decisions by firms is not being driven by unaffordable debt but instead the uncertainty following the UK’s decision in the recent referendum. As a result strong, robust and decisive leadership is required - and it was required three weeks ago. For that reason the hastening of the Conservative Party leadership contest and the resulting appointment of a new Prime Minister is welcome news, questions of sovereignty aside. Some leadership from the other side of the house would also be welcomed and is long overdue.
Theresa May and her cabinet should move quickly to offset falling demand by bringing ahead key infrastructure projects. Although many have become politically difficult they are overdue and the markets will be disappointed if the government looks to use the recent changes in personnel as an excuse for further delays. Early signs from May and Hammond are encouraging and are supported by today’s vote on Trident, but much more will be required.
Whilst the government’s room for fiscal manoeuvring is limited with the deficit at 4% of GDP, further monetary easing in isolation would simply risk driving unsustainable economic growth through household expenditure and debt. Alarm bells should be going off at this point!
Those who are quick to call for further monetary easing, which the BoE has as good as promised, should be mindful of the destructive nature of near zero interest rates. Particularly on the financial system, a system in which the taxpayer has invested significant resources to provide stability and support. Lower interest rate expectations, which we have witnessed in the flattening of the yield curve since the referendum, make it increasingly difficult for banks to make profits which are needed given their increased capital and regulatory costs. Negative interest rates would be disastrous. Insurance companies face similar difficulties in their attempts to match assets with liabilities and as a result are facing widening deficits. This should be a major source of concern to policy makers with an aging population, the effects of which will be exacerbated by our apparent commitment to reducing immigration.
Whilst interest rate expectations are at historically low levels commentators should be wary of the BoE’s inflationary target and therefore the source of its mandate. The depreciation of the pound is likely to have an upward inflationary effect such that the BoE expects inflation to exceed its 2% target in the first half of 2017. This could be quicker and more aggressive should oil prices increase which may hinder the BoE’s ability to meet the market’s expectations of keeping interest rates lower for longer. Cynics, of which we have a few, would suggest the BoE will be in no rush to increase rates in response to inflation given the historically high levels of government debt. However, expectations and therefore swap rates could increase very fast.
Whilst we expect the BoE to announce a comprehensive package on 4 August designed to give the economy a short, sharp boost we cautiously remind readers of the BoE’s numerous failures to follow through on their soundbites and forward guidance. This is a lesson that the market is increasingly aware of as the probability of a rate decrease by August has fallen from 90% to 60% since Thursday’s announcement.
The week ahead has a number of interesting data releases including CPI, unemployment and retail sales. However, these will largely cover the period pre-referendum and therefore offer little insight into the post-referendum economy. Expect little change in inflation and unemployment data. Retail sales figures are likely to be disappointing as the uncertainty of the vote took effect. For a sign of the post referendum economy’s performance look to Friday’s PMI figures which should reflect a slowdown.
All views expressed here are the author’s own and are based on information and data available at the time of writing.
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