Bank of England Governor Mark Carney is ready to raise interest rates from a position of economic weakness rather than strength.
The fastest inflation in four years leaves the UK central bank preparing to hike next month for the first time in more than a decade, yet it’s not an accelerating economy fanning those price pressures. Instead, policy makers are being pushed to temper less friendly inflationary forces generated by weak productivity and Brexit.
The UK has fallen to the bottom of the Group of Seven growth rankings, but also of concern is the fact that it’s far less productive than international peers. For Carney, who’s warned that leaving the European Union could worsen the situation, that means a lower rate of growth is already enough to put a strain on resources, generating unwelcome domestic pressures.
The International Monetary Fund was the latest to sound the alert on Tuesday when it said the UK has been the “notable exception” this year among advanced economies. It left its forecast for 2017 expansion at 1.7 per cent while raising estimates for the world, US and euro area.
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It’s a far cry from Janet Yellen’s build-up to the first Federal Reserve hike in 2015. While she signalled confidence in the economy, Carney has spoken of Brexit-related uncertainties delaying investment, reducing vital labour supply and creating a lower “speed limit.”
The supply capacity of the UK will expand at “only modest rates in coming years,” he said last month. While the weaker pound has boosted headline inflation, lower potential growth creates a risk of more persistent pressures as remaining spare capacity is absorbed faster. The BOE already sees inflation staying above its 2 per cent target for the next three years.
“It’s sort of the opposite of the US story, where everyone’s saying ‘if we’re raising interest rates and getting on with QE unwinding it’s because it’s a sign of strength,”’ said Victoria Clarke, an economist at Investec in London. “In the UK it’s a very different background, and there seem to be some more complicated reasons -- one of which is that they’re worried about a bit more of a persistent inflation problem.”e
There’s a near 90 per cent chance of a 25-basis-point increase on November 2, according to market pricing. That would reverse the stimulus after the 2016 Brexit referendum.
Analysis by Bloomberg Intelligence shows that since 1997, the BOE has only raised rates when quarterly growth has been at least 0.5 per cent. While expansion this year has only been 0.3 per cent, for the BOE, reduced potential means that’s enough to erode spare capacity.
The BOE doesn’t publish a figure for potential economic growth, though policymaker Michael Saunders estimates it’s about 1.5 per cent, below the pre-crisis average of 2.5 per cent.
The picture is in contrast to the one presented when the bank previously edged toward a hike. Former Chancellor of the Exchequer George Osborne said in early 2016 that higher rates would be “a sign of a stronger economy.”
Now, a tightening of policy might not be so triumphant.
“I wouldn’t go so far as to say the economy is doing well - I would’ve said that maybe a few years ago, but not now,” said Peter Dixon, an economist at Commerzbank AG. “The economy can live with higher rates, or slightly higher rates - given that we’re not falling off a cliff, at least not yet.”
While weak productivity growth isn’t a UK-only problem, the disappointing performance -- up less than 1 per cent in a decade - has left output per hour 15 per cent below the G-7 average. The UK Treasury said Tuesday that it’s a “long-standing challenge,” after a gloomy report from its fiscal watchdog.
Brexit could exacerbate the problem. Even with a transition period, a clampdown on migration and the threat of trade barriers may deter investment, with a fallout on the economy’s capacity for sustainable growth. European workers are already leaving, driving net migration to a three-year low.
While the BOE had been looking for a wage-growth pickup before tightening, the lowest jobless rate in four decades and the reduced supply capacity prompted it to “call time on that strategy,” according to BI economists Dan Hanson and Jamie Murray.
Gertjan Vlieghe, one of the most dovish members of the MPC, said last month that less slack alongside low unemployment and nascent signs of stronger wage growth mean that domestically generated inflation may be building.
So, rather than watching and waiting for evidence that the economy is overheating, Carney now looks poised to act.
“The economy is looking weaker, but there are risks that there’s a supply shock going on,” said Chris Hare, an economist at HSBC who previously worked at the BOE. “It’s a rate hike but partly for bad reasons rather than good reasons.”