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Inflation Reports – Bank of England November 2017

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In the inflation report of November 2017, the decision of the Monetary Policy Committee (MPC) was published. They decided to raise the interest rate by 0.25% to 0.5%. In the explanation of the decision, the MPC mentioned that the Consumer Price Index (CPI) had increased in September more than expected, reaching levels of 3%. But the concern according to the committee was not the figure of September and November, but the trend that it was taking as it was accelerating more than expected.

This is why the committee decided to increase the bank’s rate because they expected that after the adjustment of the economy due to the Brexit process, inflation had to progressively return to the 2% target, but this also required the help of monetary policy.

In the conjuncture seen by the bank at the end of 2017, there was high inflation, a deceleration in the main sectors and an economy growing at high rates compared to the last years, so the committee decided that the right decision was a moderate increase in rates.

The committee was very emphatic that future decisions would be determined over time since the United Kingdom was at a special juncture that could not be compared to any other situation before, so there was still great uncertainty as to how the negotiations would end with its main commercial partner, the European Union.

As mentioned in previous reports, the MPC was emphatic that monetary policy could not prevent the economic adjustment generated by the exit of the economic union since its commercial relationship could be affected due to a change in the negotiation parameters, such as tariffs and the free mobility of people and capital. But they admitted that monetary policy could help in the transition to be less traumatic for the British.

The growth of domestic consumption grew very slowly because the income of households and their purchasing power was not the same as they had before the elections. As in the May meeting, net trade had been reinforced by greater global expansion and a past depreciation of the pound sterling. Business investment was still affected by the uncertainty around Brexit, but it was growing at moderate rates due to better global demand, high profitability rates and low cost of capital.

With employment at low rates unseen since several decades ago, inflation well above the bank’s target and economic growth above the rates of recent years, the committee saw greater possibilities to strengthen its monetary policy for the long term to bring inflation to the target of 2%, without affecting the labour market and growth.

The committee in its report explained how the rate increase affected the macroeconomic variables. The first effect was a reduction in borrower flows and an increase in the loans obtained from commercial banks. The opposite effect was felt by savers who received higher rates of return for the money they had in banks in their savings accounts. An increase in the interest rate makes it more attractive to save today to consume in a later period and makes it less attractive to borrow due to the higher cost of the flows. And finally, the bank mentioned the effect of an increase in the rate on the exchange rate with other currencies and the valuation of British assets.

The committee did not expect the effects of the interest rate rise to be so drastic, since analysing with the stress test carried out by the financial policy committee, the committee observed a financial system that could be solvent in the face of challenging situations. In addition, about 60% of mortgages in the market were indexed at fixed rates so that consumers would not be affected so much by this measure, except for consumption because the interest rate rise will directly affect credit cards and other types of loans.

The bank also considered that the balance sheets of the companies were in good shape and the proportion of the profits required to meet the monthly payments of the debt fell to their lowest level during the last two decades.

In the expectations of the committee as already mentioned, it was projected that monetary policy would continue to support the economy and the labour market, but it was expected that during the next meetings the interest rate would continue to increase moderately to control the long-term inflation.

Brexit remained the main concern of the economy and the bank, because without having finished their negotiations, the impact felt in the economy was strong and the economy was still accommodating by a currency that depreciated, which increased the prices of imported goods and an economy that was growing at slow rates, despite the fact that world growth was improving significantly. The following chart shows the main sectors of the economy and how they change their contribution to economic growth.

Graph 58.  Contributions to average quarterly GVA growth. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

In the MPC vote, it was decided to raise interest rates with a result of 7 to 2 in favour of the measure. The committee voted unanimously to maintain the sterling stock of investment grade non-financial grade bonds at £10 billion. The committee also voted unanimously to keep the stock of purchases of UK government bonds at £435 billion.

On the international scene, the committee observed a global economic acceleration during 2017, including the G7 (excluding the United Kingdom). All measures of investor confidence and demand for products have remained robust throughout the year and have exceeded the expectations that had in committee. Despite this, the United Kingdom has not benefited from this international panorama.

This better outlook for global growth and the confidence of the markets since 2016 has been an important factor in boosting the prices of risky assets in the world and financial conditions in many countries. Despite this, the growth of the UK during the first half of 2017 was modest and investors were still very cautious with their projections about how the negotiations between the UK and the European Union would culminate.

With the volatility existing since the referendum, the pound sterling has lost about 15-20% of the values reached at the highs of 2015. In addition, the price of the shares of companies concentrated in the United Kingdom has suffered severe discounts in relation to companies from the same sector that are located in other countries. The following chart shows the behaviour of the pound sterling.

Graph 59. Sterling exchange rates. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Regarding the labour market, the committee observed a drop in the unemployment rate, but a timid response of wages to this narrow labour market. An explanation to this phenomenon where there are fewer unemployed, but the salary does not increase could almost be due to the fact that there are many people who have stopped looking for a job or are underemployed, so we see an unemployment rate that should be higher. If that were the scenario of the labour market, companies could still find skilled workers without having to raise wages to attract that new workforce.

The expectations that the committee had about inflation were a little moderate because if agents expect high inflation in the future in basic goods and wages, future inflation will be high and will have persistent factors. Therefore, the committee took the decision to raise interest rates. In some surveys conducted, it was evident that agents did not believe that inflation would be in the short range in the short term.

In conclusion, the main conclusions reached by the committee and the possible risks faced by the economy of the United Kingdom at the November meeting were:

  • Global growth remained strong and accelerated in recent months.
  • Net investment and trade supported British demand, but the growth of domestic consumption continues to show moderate rates which are consistent with the loss of purchasing power of households due to the depreciation of the pound sterling.
  • Significant upward pressure on inflation from imports and energy prices has increased the pressure on expectations for the coming quarters. Inflation has been very close to 3% between November and October and the speed for inflation to return to the target rate will depend on how quickly these pressures disappear as well as on the behaviour of domestic prices.

The following table shows the projections of the main variables by the committee.

Graph 60. Forecast summary. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Compared to the projections that the bank had at the meeting in May, a lower GDP was expected due to the slow growth of the economy where the services and consumption sectors have affected growth. Inflation accelerated in the last months of the year, so the intervention of the bank was necessary, increasing interest rates. It is also possible to analyse that the labour market has continued its positive path with a significant reduction in the unemployment rate, but wages have not kept pace and it is possible that some people have left the labour market and have stopped looking for work which is not an advance of the economy.

The Bank of England has been consistent with the conclusions it drew at its previous meetings where it was evident that the rate hike could not be very aggressive due to weak economic growth and the lack of response from rising wages, but at very moderate rates. The bank in its two meetings prior to the November meeting had stressed that monetary policy could be adjusted in any direction since as the United Kingdom was in a special situation and there was no certainty about what the conditions of the economy were going to be at the end of the year.

The increase in rates at the November meeting is consistent with the behaviour of inflation that accelerated during the last months of 2017 reaching close to 3%, which is considered the maximum level allowed for deviation from the target range. What also helped make the decision was the good behaviour of unemployment that continues to decline to levels not seen for a while.

It is clear that the bank does not rule out future low rates depending on how the main economic variables will continue since it is the first time that the committee faces a situation of this type. But it is likely that in 2018 there will be an increase in rates by the MPC if inflation is still well above the target.

Graph 61. Averages of other forecasters’ central projections. Retrieved 5th February 2018 from   https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf#page=42

 

If we analyse the projections of agents that do not belong to the Bank of England, we can appreciate that the projections for the next three years are similar to the expectations that the bank had in the November meeting. The variable that most differed in the projections was the unemployment rate. As mentioned above, the British labour market has presented a strange situation showing very low unemployment rates in recent periods, but not with wages so there could be some imbalance in the labour market to explain this. This is why it is important to monitor in the future how the labour market will continue to behave in order to have an indication of what the next monetary policy decision will be.

It is also evident that inflation will be above the target range until 2019 according to surveys made to market agents and for the Bank of England, the goal will not be achieved until after 2020. This will be the most decisive factor to project future decisions of Monetary policy since by mandate the main objective of the bank is to maintain price stability. According to the inflation reports, it is expected that by the end of 2019 the Brexit negotiations will be completed, so until that moment it will be clear what the terms of trade will be between the United Kingdom and the European Union, so it is not expected that in the short term, the pound sterling will stabilise.

Graph 62. GBP/USD. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

If the market response is analysed after the November meeting, it can be seen from the graph that sterling continued to appreciate in the last months of the year, so it can be concluded that the markets have received the decisions of the MPC well, and expectations are no longer as pessimistic as a year ago.

But if its value is compared with the Euro, that appreciation has not been generated and remains at low levels since the decision was made to leave the European Union. So, there is still much uncertainty about what the results will be at the end of Brexit, which means that the pound sterling has not yet recovered the levels it had before the elections.

Graph 63. GBP/EUR. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

 

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