17 October 2017
The debate this time last year cantered on the likelihood that the Bank of England (BoE) would ease policy further. Fast forward and the Bank looks set to deliver the first rate hike in around a decade. Sadly, this is not against a backdrop of blockbuster growth. Instead, the Bank is set to start tightening policy in a sluggish environment, as the Monetary Policy Committee (MPC) becomes increasingly convinced that the slowdown reflects a fall in the UK’s potential growth rate. If it is right, then policy needs to be adjusted to avoid overheating. There are concerns about the pending shift. Some comfort may be taken from the Bank’s guidance that any tightening will be gradual. Markets are discounting one rate hike this year, and one in 2018, in line with our expectations (see Chart 4). However, there are still residual worries. First, the Brexit process remains uncertain, with negotiations having still not started on a transition agreement. Second, the economic backdrop remains challenging, with consumer incomes under pressure and businesses cautious on investment.
The Bank is well aware of the risks around Brexit. If the UK failed to agree a transition arrangement, it would face a cliff edge as the Article 50 deadline is reached in March 2019. The recent shift in MPC rhetoric reflects a desire to no longer keep policy pre-emptively weak amid this risk, but become reactive should it materialise. Therefore, the MPC will be watching negotiations closely for signs that sufficient progress is being made. We have identified a number of waymarks which would suggest the probability of a World Trade Organisation scenario is rising. These include increasingly hostile negotiations; few signs of compromise on the four freedoms; or greater influence of Eurosceptic voices in the Conservative party.
What about concerns that tightening could do more damage than expected to growth? Households are already under pressure from inflation, while aggregate debt remains high from a historical standpoint and chronic among a small group of households (see Chart 5). Around 40% of mortgages are on variable rates, and fixed-rate mortgages tend to be on relatively short terms. Moreover, consumer credit has been growing quickly. Limited rate hikes should provide a moderate drag on incomes, but there are risks that consumers cut spending disproportionately and opt to save more, especially if they fear a more rapid adjustment. We will need to monitor consumer confidence, retail and cars sales, and broader services data closely for signs that spending is performing worse than anticipated. The housing market is another area of potential sensitivity. The secondary market has softened over recent quarters, although new housing activity has been more robust, supported by Help-to-Buy. We will need to keep a close eye on lending standards, credit demand, mortgage approvals and transactions to get a sense of how the market is weathering higher rates. Finally, the corporate sector has deleveraged over a number of years and is in better shape from a balance sheet perspective. Small increases in rates should not materially affect investment decisions, although if this triggers broader stress in the economy then firms are likely to factor this into their planning. Overall, the likelihood is that moderate tightening does not derail growth. If the effect proves more onerous then the Bank should be flexible around its plans.