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Inflationary pressures could push the Bank of England to increase interest rates. Ed Hutchings* questions whether such a move is justifiable.

A sharp rise in inflation over the last year, from 0.7% in May 2016 to 2.9% a year later is prompting speculation that the Bank of England may raise interest rates in the coming year.

Three members of the Bank’s Monetary Policy Committee (MPC) voted for a rate hike at the June 14 policy meeting. MPC member Ian McCafferty recently called for two rate rises over the next two years1, while another member, Andy Haldane, the Bank’s chief economist, said monetary policy should be tightened before the end of 2017. On June 28, the governor of the Bank of England, Mark Carney, also suggested interest rates could rise if business investment grows2.

Against this backdrop, Ed Hutchings*, Senior UK Sovereign Portfolio Manager at Aviva Investors, discusses whether economic conditions warrant a tightening of monetary policy and the likely impact of a rise in interest rates on the fixed income market.

Is concern over inflation justified?

Carney has highlighted the transitory nature of inflation on numerous occasions. The sharp rise in inflation over the last year is mainly a result of the depreciation of sterling following the EU referendum and much of the impact has now fed through. Nevertheless, in its latest inflation report3, the Bank of England said the fall in sterling is likely to keep inflation above its 2% target throughout the next three years and that arguably gives the MPC the basis for a more hawkish stance.

So how likely is an increase in rates?

Given the uncertainty surrounding the UK’s economic prospects, it is difficult to argue that interest rates should go up. Weakening consumer spending highlights the dangers of such a move. Perhaps the most worrying aspect of Q1 2017 GDP data was the slowdown in consumer spending to 0.3%4, the weakest growth for more than two years. The savings rate has recently fallen to a record low5 and car sales fell in June for the third month in a row6, providing more evidence of the pressures facing the consumer.

The latest construction, manufacturing and service sector PMIs have all moved lower, signaling prospects for the UK economy are weakening from earlier in the year7. Beyond this, the outlook for the economy is likely to remain unclear until Brexit negotiations in two years time. Even then, there may be a transitional period that would cloud the UK’s economic outlook for even longer.

The mixed messages from rate setters at the Bank of England reflect this lack of clarity. Ben Broadbent, the Bank’s Deputy Governor, said on July 12 that he is “not ready to raise interest rates” due to there being too many “imponderables” in the economy8.

Despite the economic weakness, could the MPC still vote to raise rates?

The main argument for a rise would be related to financial stability given it’s hard to justify in economic terms. The Bank of England could simply decide to reverse the emergency rate cut implemented following the Brexit vote. That could be a means of signaling to the financial markets that the extraordinary monetary policies adopted by the Bank will not be in place indefinitely. While there is little to suggest central banks globally are coordinating their policies in this area, members of the MPC have been making hawkish remarks about monetary policy at the same time as we are seeing similar rhetoric from rate setters at the European Central Bank (ECB). Jens Weidmann, head of Germany's Bundesbank and a member of the ECB's rate-setting body, said on July 1 the ECB is working on moving away from its ultra-easy monetary policy9. The monetary stimulus taps are certainly being turned off, albeit at a very slow pace. 

If it does vote to increase rates, would you expect a consistent path of hikes or for the Bank of England to follow the same stop-start path pursued by the Fed?

It is unlikely the Bank will embark on a major rate-hiking cycle. On July 4, UK Asset Resolution, the state-owned group responsible for winding down the mortgage books of several failed lenders, warned up to 10% of its customers could struggle if interest rates rose by one percentage point. Such a rise would potentially hit the consumer and the economy quite hard, particularly as lenders are already tightening their credit criteria or restricting loans following pressure from the Bank of England10

What impact would a rate hiking cycle have on the economy?

A significant rate-hiking hiking cycle could have a severe impact given all the unknowns related to the economy over the next two years and more. Such a development would be wholly inappropriate in my view.

What impact would a rate hike have on the fixed income market?

The market has priced in at least one rate hike over the next year, while it is also saying there is a 68% chance of a hike over the next six months. McCafferty called for two hikes over the next two years and the market has already priced in a significant amount of that. Overall, I can't see a rate hike having a major impact on the fixed income sector, although the timing of such a move could be a factor. The market isn't expecting interest rates to rise in August, but even if they were to go up next month I suspect the market would digest the news fairly easily.

If the Bank of England does hike, it is likely to be in the second half of the next 12 months. That is certainly what the market is pricing in. However, I am not certain the Bank will raise rates at all given the uncertainty.

Have investors reacted to the recent spike in inflation?

Investors in UK gilts sold bonds after the unexpectedly close vote by the MPC in June and the yield on the 10-year benchmark has been rising steadily since. Inflation data and hawkish comments from rate-setting members of the MPC have played a part. But the recent rise in yields is not confined to the UK. Ten-year German bund yields, and most other euro zone sovereign debt yields, along with US treasuries, have also been moving upwards as investors refocus on the outlook for global central bank policy.

 

* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").

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