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10 May 2018 | By Mark Nash

BoE interest rate decision

Recent weakness in the economic data and Brexit uncertainty saw the Bank of England back away from raising interest rates. However, the market’s move to price fewer rate hikes globally in the future could be short sighted.

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The Bank of England (BoE) chose to keep rates on hold at today’s meeting in light of recent weakness in GDP, falling house prices, lower-than-expected inflation and, no doubt, Brexit uncertainty. There has been broad based weakness in economic data across the globe, ex-US, after a strong Q4 2017 that has led central banks to back away from rate hikes in the near term. That leaves the US Federal Reserve (Fed) with inflation at the 2% target as the outlier.

The market has also moved to price lower interest rates in longer maturity debt and fewer rate hikes in the future. This could be short sighted for two reasons. First, in a globalised world, inflation tends to move in tandem with the global output gap, which is the dominating factor in predicting domestic inflation. The BoE and Mark Carney have been at pains to speak about this when they were justifying their dovish stance in recent years when inflation was above their 2% target. They claimed, rightly, that it was down to imported inflation due to the weak pound. As US inflation hits the target, this argument should be repeated to remain alert to inflation when policy rates are at record lows.

Secondly, in the post crisis aftermath central bank policy has been slavishly followed by the market on the back of weak demand and deflation risks. This isn’t the case now as negative inflation fear has become a distant memory. With output gaps closing, seeing a weak patch in growth is unfortunate but is not the only consideration as supply constraints rise in importance.  The markets avid focus on what central banks will do at their next meeting should be left to the crisis era as demand in the economy catches up with supply. This is before the lack of population growth due to a Brexit exodus and lower levels of investment are taken into account, and amounts to a supply shock for the UK. The BoE should remain vigilant and the market should look towards the inevitable endgame of higher UK interest rates and price them accordingly.

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