“The Bank of England’s (BoE) trade-off is beginning to give the central bank some discomfort: engaging in record low interest rate policy to promote job growth at the expense of the damage to real incomes is growing more risky, as unemployment falls to 30-year lows and CPI inflation rises to 2.9%.
“Output gaps matter and that of the UK is not wide – the BoE has just decided to remind the market about this. The Monetary Policy Committee added that eroding slack, due to Brexit-related weakness in investment, actually reduces its tolerance towards higher inflation. This year, UK aggregate demand levels have fallen on the back of a slowdown; however, a dimming supply-side outlook also needs to be considered when predicting future inflation.
“The BoE’s formal nod to interest-rate increases in coming months, as delivered in its statement today, is a clear indication that the market has got this wrong, failing to price in any hikes meaningfully in the near term. It is also likely the central bank is not happy with the large fall in sterling on a trade-weighted basis, either.
“In the market’s defence, Mark Carney, BoE governor, went out of his way in August to play down the risks posed by low rates to financial stability; this, at the time, appeared like a clear greenlight to push back expectations of interest-rate increases and to sell the pound.
“Still, the market’s incessant emphasis on Brexit negotiations, in which Europe is seen as having the stronger hand, has spurred investors to look through output gaps. With unemployment still over 9% in the euro area, this focus may prevent investors from accurately gauging the direction of sterling’s value versus the euro, in our view.”