Macro Flash

Will the BoE cut rates? While the dovish tone of some policy makers in recent weeks leaves open the prospect of a cut at the first Monetary Policy Report of 2020 (Thursday 30 January), the growing evidence of a material improvement in economic conditions since the 12 December election will likely suffice to keep the BoE on hold for now. The policy meeting will be Mark Carney’s last one as governor.

We have already discussed the case for and against a rate cut -here and here. In addition, four key issues will likely shape the outcome:

1. The policy decision may depend upon how much weight policy makers put on the post-election survey data
Two policy makers already voted for a cut in November and December last year (Michael Saunders and Jonathan Haskel). Two further policy makers Gertjan Vlieghe and Silvana Tenreyro have said that they could too vote to cut rates unless they saw enough evidence of an economic improvement soon. The uptick in confidence and activity in the post-election survey data suggests the economy is recovering from its 2019 sluggishness. Vlieghe and Tenreyro will thus likely remain on hold. However, the sharp – but short-lived - deterioration in survey data after the 2016 EU referendum may cast some doubt in the minds of policy makers over the durability of the post-election bounce. We see a 40% chance that a majority of the nine member committee votes to cut rates. The market currently prices in a c54% chance of a cut, down from c70% some two weeks ago – Chart 1.

Base case: 7-2 or 6-3 split in favour of keeping rates on hold with a dovish tone to the minutes and guidance, especially in light of the recent dip in headline inflation below the BoE’s 2% target – Chart 2 – and a somewhat fading of the still-elevated inflation expectations – Chart 3. Although the positive news since the election will likely keep the BoE in ‘wait and see’ mode, the BoE could downgrade its near-term headline forecasts slightly after the weaker-than-expected hard data ahead of the election in Q4.

2. The BoE will not yet fully factor in the growing chance of a fiscal stimulus
Fiscal plans are a tricky issue for the BoE. Based on Chancellor Javid Sajid’s fiscal guidance - to lift net investment to 3% of GDP and trend real GDP growth to the pre-financial crisis average of 2.7-2.8% (which is unattainable on a sustained basis) - we put a high probability on a major fiscal coming from the 11 March Budget. On top of the 0.2ppt boost to growth from the rise in planned spending announced last September, we estimate that the Budget plans could add up to 0.6ppt to headline growth this year. It could thus lift the BoE’s November 2019 projection for 2020 from c1.25 to c1.85% - roughly in line with our own forecast. While Carney may emphasise the fiscal outlook as an upside risk to the outlook for growth and inflation the BoE will need to wait until parliament passes the legislation before raising its forecasts - that will come at the May round. For now, the potential upside risks to growth and inflation from fiscal policy will strengthen the case to keep rates on hold.

3. A rate cut would set back any medium-term policy tightening
We would expect any cut to be ‘one and done’ with no further easing of policy thereafter. A rate cut would, however, cast some risk over our call for a rate hike in H2 2020. The BoE’s reaction function is asymmetric due to low rates and global disinflationary pressures. It thus reacts much more slowly to inflation risks than deflation risks. After a cut, the BoE may also be reluctant to reverse course fast with a hike as that may imply an admission that the cut may have been a mistake. Unless growth and inflation surprised to the upside a lot in H2, the next hike could be delayed until 2021 if the BoE cuts rates this week.

4. The BoE’s annual assessment of supply could alter the policy outlook
The BoE typically conducts it annual assessment of supply-side conditions at the first round of each year. The updated assessment of the UK economy's potential growth rate, long-run equilibrium unemployment and employment rates, and the amount of spare capacity in the economy may change the policy outlook. One potential surprise could come if the BoE estimates that the current unemployment rate of 3.8% is well below the long-run equilibrium rate. Hiring has remained solid since the Brexit vote while business investment has stagnated. But firms may prefer a more capital-intensive production method. With more Brexit clarity, there is some risk that firms reduce the pace of hiring in favour of higher capital investment. That would simultaneously raise productivity and increase slack in the labour market. By lowering unit labour costs, it would tilt medium-term inflation risks to the downside.

Base case – BoE on hold before a first rate hike in H2
We expect the Monetary Policy Committee (MPC) to keep its two key pieces of guidance unchanged from the December meeting:

1) 'if global growth failed to stabilise or if Brexit uncertainties remained entrenched, monetary policy might need to reinforce the expected recovery'

2) 'provided these risks did not materialise and the economy recovered'.... 'some modest tightening of policy, at a gradual pace and to a limited extent, might be needed'

If the MPC sticks with its December guidance, we would continue to expect the BoE to remain dovish - but on hold in the near-term - before dropping its dovish bias in mid-2020 in line with improving economic conditions. An economic rebound, reinforced by a fiscal stimulus, suggests the most likely next move for rates is up, eventually. We look for a 25bps rate hike in H2 2020. That would take the bank rate to 1.0% by year-end. Expect one further hike in 2021.

Kallum Pickering
Senior Economist

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