On August 7, 2014, the Bank of England's Monetary Policy Committee (the "MPC") announced their decision to keep the Bank Rate at 0.5%. While the decision to keep rates steady was no surprise, the minutes from the MPC meeting released on August 20, 2014 revealed that two members of the MPC, Martin Weale and Ian McCafferty voted to raise interest rates by 25 basis points from 0.5% to 0.75%.
The two dissenting members pointed to a rapid fall in the unemployment rate as well as surveys that indicated a tighter labor market as reasons to tighten monetary policy. While rises in wages were anemic, the two dissenting members believed that wage growth was lagging other developments in the labor market, and that since changes in the economy also lagged changes in monetary policy, tightening of monetary policy would coincide with increases in wages.
With unemployment rates dropping quicker than previously predicted by the Bank of England, lackluster wage growth, and more specifically the role of labor market slack in slow wage growth, seems to be the new battleground for hawks and doves on the MPC. Bank of England deputy governor Ben Broadbent also voiced his views in Jackson Hole, stating that there was uncertainty as to whether wage growth would result from the improving labor market.
The August Inflation Report also reports on the puzzling anemic wage growth. Four possible reasons were given in the August Inflation Report: 1) Measurement issues due to changes in the composition of the labor market; 2) a lag in wage growth; 3) a lower medium-term equilibrium unemployment rate (or greater labor market slack); and 4) a higher medium-term equilibrium participation rate.
Measurement issues may have had some effects, especially due to a good portion of the recent job growth being attributed to growth in low skilled jobs. However, while we believe that "compositional effects" have had a greater than expected effect on the low levels of wage growth, we concur with the Bank of England in that there are other factors leading to downward pressure on wage growth. The hawks on the MPC have rallied behind the idea that wage growth is merely lagging, and that with time, will catch up with the other labor market indicators. In contrast, the doves have justified their stance on the belief that there is greater labor market slack and a high equilibrium participation rate.
The markets have anticipated a rate hike. According to the Monetary Policy Committee, financial markets have priced in a 25 basis point increase in the Bank Rate in the first quarter of 2015, while economists surveyed held a less sanguine view on the possibility of a rate hike.
Reasons Why The MPC Will Delay Raising Rates
While financial markets have priced in a 25 basis point hike in the first quarter of 2015, it is our belief that the economists are correct and that the MPC will refrain from any monetary tightening till at least the second quarter of 2015.
The gilt yield curve indicates that inflation expectations are contained with the 10-year gilt at 2.40% and the 30-year gilt at 3.09%. Furthermore, the curve has flattened since a year ago when the 10-year gilt was at over 2.70% and the 30-year at 3.6% . With the yield curve flattening (perhaps due to expectations of monetary tightening), it would seem as if the bond market is signaling that tighter monetary, while expected, would be premature with no indication of inflation.
The United Kingdom is also plagued with a high level of debt relative to GDP. In a report issued by McKinsey & Company, the United Kingdom had a total debt of 507% of GDP in Q2 of 2011. Household debt was at 98% of GDP, non-financial corporate debt at 109% of GDP, debts held by financial institutions at 219% of GDP and government debt at 81% of GDP. The numbers have improved somewhat as total debt to GDP fell to 484% at the end of 2013. For the most part, the fall in debt to GDP ratio is due to GDP expanding at a higher rate than total debt, and not because the absolute amount of debt has fallen. Even with the ratio having fallen a significant amount, 484% total debt to GDP would still rank the United Kingdom as the third most indebted country after Japan and Ireland amongst countries with developed economies. If the Bank of England were to raise interest rates, real interest rates will undoubtedly go up, possibly leading to a resumption of total debt increasing.
On a related point, the importance of the financial sector for the UK economy cannot be understated. The financial sector, while recently maligned by government officials, comprises approximately 10% of GDP and is a key cog in the UK economy. Indeed, the extraordinary measures employed by central banks such as quantitative easing may have had an outsized positive influence on the UK economy compared to other economies that are less dependent on financial services. Likewise, raising short-term funding will most likely impact the UK economy more acutely as output from financial companies contributes to a greater proportion of GDP. Higher interest rates will increase the cost of borrowing, but may also decrease revenue derived from lending as the yield curve will flatten. This will result in narrower net interest margins for financial companies.
The MPC will also be reluctant to raise rates due to the de facto tightening via the exchange rate. The pound sterling (NYSEARCA:FXB) has been remarkably strong in recent months against the euro (NYSEARCA:FXE) as shown here in a chart of the pound-euro exchange rate.
Deflationary pressure will undoubtedly be imported due to the weaker currency, weakening inflationary pressures. We suspect the deflationary pressures of a strong pound has yet to fully impact prices, as the pound strengthened significantly in April 2014 against the euro.
A rising participation rate in the labor market, greater than estimated slack in the labor market, and composite effects on wage growth have all contributed to the anemic growth in wages. By attributing the lack of wage growth solely, or even primarily, to a lag effect, seems shortsighted by the hawks on the MPC from a holistic perspective.
The MPC, like the Federal Reserve, is in no hurry to raise interest rates. Especially with inflation data coming in consistently below 2% this year, the MPC is unlikely to presume that wage growth will follow the recent labor market improvements. Even if the two dissenting MPC members are correct and wage growth is lagging, there are few drawbacks to taking a wait-and-see approach. We believe that a rate hike by the Bank of England is not imminent and will occur in the second quarter of 2015 at the earliest.
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