Recently, the Bank of England (BoE) decided to maintain its historic low interest rates. The (for some) unexpected collapse in petroleum prices, which occured last autumn, has caused CPI inflation to drop sharply in recent months. In this article I will highlight the consequences this has for the UK, and focus on the moment of expected yield hikes in particular.
Libor and CPI
The effect of the oil nosedive on the CPI can be seen in graph 1. The 0.3 percent rate that was registered in January was the lowest year-over-year. The Monetary Policy Committee (MPC) of the BoE has an inflation target of 2 percent that it attempts to maintain over the medium term. A CPI inflation rate that is well below this target makes it difficult for MPC members to justify a rate hike in the coming months.
Indeed, during January the BoE’s main policy rate of 0.50 percent was maintained with fewer opposition than previously expected.
In line with this, financial markets have also scaled back their expectations of MPC policy tightening. In July 2014, the implied yield on the three-month sterling LIBOR futures contract that matures in December 2015 were at 1.80 percent (graph 2). This implied yield shows that, at that time, investors were anticipating a rate increase of around 100bps-125bps by December 2015. The steep decline of 100 bps that we have seen since then indicates that investors now anticipate the MPC to increase the BoE rate by around 25bps in December this year.
Another look at CPI
Figure 1 also shows that although the overall rate of CPI inflation currently stands at only 0.3 percent, the core CPI inflation rate, which excludes oil prices, is higher at 1.4 percent.
This means that if petroleum prices remain close to current levels for the rest of the year, the overall rate of CPI inflation will return to the core rate early in 2016 when the nosedive in oil prices drops out of the year-over-year calculations. If the oil prices rise from current levels we can expect the overall CPI inflation rate to recover to the core rate before January 2016.The return of the overall rate of CPI inflation to the core rate could occur prior to January 2016 if oil prices rise from current levels. The MPC explicitly targets the overall CPI inflation rate, however, the core rate of inflation probably plays an important role in the forecasts of the overall inflation rate.
The unemployment rate has declined to less than 6 percent, the lowest rate since the economy plunged into recession in 2008 (see graph 3).
Most indicators suggest that the British labour market continues to tighten. Consistent with the tightening that has occurred in the labour market, there are some modest signs of wage acceleration in the UK economy (see graph 4). Since services comprise 60 percent of the core price index, and wages and salaries tend to be a large cost component for many service providers, we can expect this to have a positive effect on inflation.
These two opposing effects of increasing labour participation and lower oil prices will thus have to decide in which direction the CPI inflation will head.
Rate hikes and the sterling
The latest quarterly Inflation Report, which presents the BoE’s macroeconomic forecasts, shows that the BoE expects CPI inflation to be back to target in about two years. In constructing its forecasts, the BoE assumes that interest rates will rise in line with market expectations, which currently is about 100 bps of rate hikes by December 2017. The implication is that the MPC understands it will need to raise interest rates if it wants to prevent CPI inflation from significantly exceeding its 2 percent target in 2 years.
If CPI inflation rises above 1 percent on a sustained basis by late summer/early autumn this year, then it is likely the MPC will begin to hike rates in Q4-2015. Since the BoE’s staff officially updates its macroeconomic forecasts in the middle month of each quarter, we believe that November would be the most likely month for the first rate hike.
The outlook for BoE’s policy has implications for sterling exchange rates this year. When the Federal Reserve (Fed) starts raising rates first - which is likely - we can expect the US dollar to appreciate modestly against the British pound in coming quarters. On the other hand, the sterling should strengthen somewhat against the euro since the ECB policies are more accommodative rather than tightening for the coming 1.5 year.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.