It has now been 10 years since the Bank of England (BoE) last hiked interest rates, the longest pause in such action since World War Two. In the week when the US marks its Independence Day, we wonder, is a similar spirit of independence running through the halls of Threadneedle Street?
As major developed-market central banks, including the US Federal Reserve, the European Central Bank and the Bank of Canada, stake some independence from inflation – the BoE is put under even more pressure to follow suit.
The ethos of these central banks is shifting. Inflation targets look out of date in today’s globalised world, amid inflation-busting technological progress. Economic growth is strong – and that matters. Therefore, tighter policy is needed; this is what central banks are telling us.
In markets, tighter policy should translate into higher risk premia across the board. Investors have chased financial asset prices higher on the back of falling global inflation in recent months, expecting monetary policy to remain loose for even longer. We believe this behaviour is misguided – investors should be wary of buying in now, as change is on the way.
The BoE is now facing a similar scenario, but also has a number of potentially influential factors to consider. The monetary policy committee (MPC) has maintained for some time that there are no domestic price pressures, so putting policy on hold has been appropriate. The much-published and very shallow ‘dip’ in growth in the first quarter of this year is, in our view, not enough to justify depression-level monetary settings.
The British consumer continues (dangerously) to sustain the economy, as savings rates fall to new lows. Wage rises are low, but with high headline inflation and record low unemployment, worker bargaining power is rising. The UK has a weakened government that can no longer say ‘no’ as anti-austerity sentiment sweeps through parliament.
The electorate appears to believe in the ‘magic money tree,’ and why not? After all, its fruit was plucked to bail out the banks. As Remainers find their voice, opinion polls now suggest the majority of the British public favour the UK remaining in the EU, and a straight-bat Chancellor of the Exchequer is telling us Brexit might mean higher taxes; it seems as though Brexit is getting softer by the day. Dare I suggest it might not happen at all?
It has been 20 years since the BoE gained its independence and was set an inflation target; perhaps the potential end of the inflation-targeting era is the more relevant milestone for markets today. Cracks are showing in the MPC already, as the rug is slowly being pulled out from under its core arguments to keep rates low. If any asset is in need of a risk premium, it is the UK gilt market.