Bank of England readies for the wave of fresh data due out on Thursday - the first ever joint-release of rate announcement, MPC minutes, and the Inflation Report.
The nine-strong rate-setting committee is expected to keep monetary policy stance unchanged in August, but economists expect a rift around the outlook for inflation. Two policymakers, Martin Weale and Ian McCafferty, could possibly vote for a rate hike as early as in August. Both policymakers were voting for a 25 basis point rate increase already last year, between August and December 2014, before they dropped their vote in January, when inflation was falling sharply towards zero.
Also, David Miles is possibly joining the minority at the Monetary Policy Committee (MPC) as his most recent comments showed that for the first time in his six-year term at the MPC, ending this August, of a willingness to vote in favor of an interest rate increase.
Even though the UK economy picked up pace notably in the second quarter, the overall macro environment in which the Bank of England is about to publish its new forecasts, and decide on the path of monetary policy, has become more complicated and complex. While the Greek crisis has been tamed for the time being, other headwinds from across the world continue to weigh on the outlook.
External downward price pressures, making up nearly three quarters of the downward CPI deviation, keep the UK consumer inflation significantly low, while a tentative uptick in domestic upward pressures in the form of wage growth suggest a healthy offsetting factor.
Global Oil prices continue to hover within a bearish zone and close to this year's lows, while sterling remains on a strong footing, rising some 10.3% since the start of the year against the eurozone currency – the UK's largest trading partner.
Both of these factors are expected to continue exerting significant downward pressure on the CPI inflation outlook. The August Inflation Report forecast should shed more light on how much weight and persistence the policymakers attribute to those pressures, and how much it affects their medium-term outlook for inflation.
In the July MPC minutes, policymakers judged that the recent sterling appreciation will have "a direct effect on inflation, bearing down on the CPI relative to the outlook described in the Committee’s May forecast, although the speed and degree of pass-through from movements in sterling was uncertain." Lower oil prices, if persistent, would also weigh on the inflation outlook, the logs added.
A notable offsetting factor should come from slowly increasing domestic costs, as wage growth is expected to continue rising to at least the levels seen before the 2008 financial crisis. The latest official figures showed the regular average weekly earnings, those stripped of bonus payments suggesting a more underlying pay growth, rose 2.8% in the quarter to May – the largest increase in more than six years – while the jobless rate rose for the first time since 2013, up one tenth percentage point to 5.6%.
Despite wage growth picking up pace recently, it still remains well below the pre-crisis levels. While earnings increased on average by 4% before the crisis, between 2001 and 2008, the same measure of pay rose just 1.6% on average between January 2009 and May 2015.
Rift at MPC looms
Though all of the above creates a puzzle, both the BoE and the US Federal Reserve (Fed) have been slowly but surely preparing both markets and households for normalization of their respective monetary policies. At least that is what the rhetoric on both sides of the Atlantic suggests.
So far in the UK, three MPC rate-setters indicated they would prefer that the BoE begin increasing rates sooner rather than later.
BoE's David Miles said recently he had "one more meeting on the Committee and it will coincide with the MPC's August Inflation Report. It also comes at a time when I think the case for beginning a gradual normalization in the stance of monetary policy is stronger than at any time since I joined the committee over 6 years ago."
Ian McCafferty told Market News International on July 23 he did not think "its mechanical you say 'well, the earlier you start the more gradual you can be', but at the same time, I think if we are minded to be gradual for good reasons, then I think we need to be careful not to leave it too late." But he also reiterated that "the exact timing of lift-off is going to be heavily data dependent over the course of the coming months."
Similarly, BoE policymaker Martin Weale suggested in his recent interview with the Financial Times that the MPC should stand ready to start raising the base interest rate as early as in August this year, as the UK labor market continued to tighten markedly.
Last but not least is the comment from Governor Mark Carney who said on July 14: "The point at which the interest rates may begin to rise is moving closer, given the performance of the economy, consistent growth above trend, affirmative domestic costs, kind of balanced somewhat by disinflation that we are are importing from abroad in part due to the strength of the currency."
Gradualism
A common stance among economists is that BoE will begin tightening policy with a conventional 25 basis points each rate hike. But given the policymakers' constant reiteration on gradualism and a slower tightening process, analysts at the Bank of America (NYSE:BAC) Merrill Lynch argued the MPC might as well start the tightening cycle with a 10 basis-point hike instead.
"We see several compelling reasons why it might be considered and expand upon our original case inside. A small and tentative first increase might plot a careful course between compelling but competing economic arguments and minimize the risk of what we call a 'Bayesian shock' accompanying the first rate increase," economists at the Bank of America Merrill Lynch suggested in their July's 'Liquid Insight' report.
The above argument would make sense given the BoE top officials stressing constantly that it is not so much about the timing of the first hike, but rather about the actual monetary path that follows. That path will be much smoother, slower, and more gradual than in previous tightening cycles, with rates staying lower for much longer than was common practice before the crisis. This also reflects BoE Governor Mark Carney's recent comments saying "the actual path almost certainly will not be mechanical, linear or pre-determined."
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