Although recovery of the British economy has been broadening over recent quarters, sustainability of the recovery is not yet certain. Improvement in some areas continues to be offset by weakness in others, including weak wage growth, high youth unemployment, soft property prices outside London and the southeast, and low money and credit growth. For this reason, any precipitate action to raise interest rates or tighten monetary conditions - which would inevitably affect all sectors - would be premature and likely cause a significant setback. So while the recovery is moving into a self-sustaining stage, I wouldn't expect a rate hike until year end or in early 2015.
Progress and problems
On the positive side:
- I believe employment will continue to rise, reducing slack in the labor market, although a few pockets of weakness by area and age group may still remain.
- Gross domestic product growth, which finally started returning to more normal rates in 2013, has broadened from being driven solely by consumption to include business capital spending, housing and exports - at least until first quarter 2014, when weaker exports likely reflected slow growth in Europe and the strength of sterling over the last year.
Nevertheless, challenges remain, including:
- Credit growth remains minimal, even in housing and business lending, despite the two government credit promotion schemes - "Funding for Lending," designed to incentivize banks and building societies to boost their lending to the U.K. real economy, and "Help to Buy" to boost home purchases. While households and commercial and industrial companies are seeing moderate but steady growth of their money holdings, the financial sector is still shrinking its balance sheets. The authorities need to remain vigilant that a financial sector squeeze doesn't place renewed pressure on households and industry.
- Slow money and credit growth over the past four years, together with strengthening sterling and falling import prices, will ensure consumer price index inflation remains below 2% through 2014 and most of 2015, in my view.
- While the labor market has improved notably in quantitative terms, the U.K. has a long way to go to erase the employment gap resulting from underemployment and restore the typical, normal quality of jobs. Most new jobs are still predominantly self-employment or part-time jobs.
Despite lingering problems, it seems likely that if the British economy continues to recover, and the recovery continues to broaden at current rates, the Bank of England will be the first among the major central banks to start tightening, either by implementing further macroprudential controls on the U.K. financial system - such as the more stringent lending conditions for mortgages implemented in April by the Financial Conduct Authority, a regulatory body in the U.K. - or by raising interest rates.
When the Financial Policy Committee meets on June 17, I expect further macroprudential controls to be implemented. Then, in my view, it's likely that interest rate hikes will follow after this further round of tightening controls, possibly toward the end of 2014 or early next year.
Macroprudential analysis looks at the health of the underlying financial institutions in the system and performs stress tests and scenario analysis to help determine the system's sensitivity to economic shocks.
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