By Conor Lambe, Chief Economist at Danske Bank
UK interest rates and the Bank of England have been making headlines for the last month. In May, the Bank’s Monetary Policy Committee (MPC) voted to keep interest rates at 0.5 per cent. A few weeks later, Mark Carney signalled that interest rates could still go up, but at a “gentle rate” during an appearance in front of the Treasury select committee. Then, in a speech delivered to the Society of Professional Economists, the Governor of the Bank of England discussed the impact that Brexit has had on the UK economy and how it could affect the future path of monetary policy.
Perhaps unsurprisingly, given this backdrop, interest rates are a topic that I’ve been asked about a number of times at recent events that I have spoken at. So this felt like an appropriate time to give a few of my thoughts on the events outlined above.
Firstly, why did rates not go up at the start of May? Just a few weeks before the MPC met, financial markets were expecting a rise to 0.75 per cent on 10th May. There were also some expectations of a second rise coming later in the year. I was in that camp, expecting to see interest rates finish the year at 1 per cent.
But as the May MPC meeting got closer and closer, things changed and it became clear that a rate rise was very unlikely. And so it was. Bank of England policymakers voted by 7-2 to keep rates as they were.
The main reason for this decision was that the economic data was not as expected. The UK economy grew by a feeble 0.1 per cent in the first quarter of the year and inflation fell more quickly than expected to 2.5 per cent in March. Subsequent data releases have continued this trend. In the second release of economic growth data, the Office for National Statistics kept the estimate of real GDP growth unchanged at 0.1 per cent. And inflation came down even further to 2.4 per cent in April.
The decision to hold off on hiking rates is understandable. The UK economy is clearly not firing on all cylinders and inflation appears to be on a downward trajectory that will eventually bring it back to the Bank of England’s target. But interest rates can’t stay at their current lows forever. Some degree of normalisation needs to happen and that will mean rates going up. It’s a decision for the MPC how quickly they will rise, but with Brexit taking a toll on the performance of the UK economy, if rates are to increase they will likely have to do so at a time when the data would not, in the past, have supported a tightening of policy.
Turning to Brexit, Mark Carney made a number of interesting points in his speech to the Society of Professional Economists. He explained that in a scenario in which Brexit is even more disruptive, such as a bumpy transition period or if a less open long-term relationship between the UK and EU ensues, the MPC would again have to decide whether to tolerate high inflation for longer than they would ideally wish in order to support the wider economy.
He also said that economic output has increased by 1 percentage point less than the MPC had projected before the referendum and that average household incomes are currently 4 per cent below what the MPC had expected before the Brexit vote, which is equivalent to over £900 per household.
Now, it is obviously impossible to say exactly what would have happened to the economy if the UK had voted to remain. Just because the MPC expected household incomes to be around 4 per cent higher does not mean that they definitely would have been. But, regardless of the precise numbers, it is very clear that Brexit has negatively impacted the UK economy. The slowdown in consumer spending growth is mainly a consequence of the high inflation (and resulting weak real wage growth) brought about by the depreciation in sterling after the referendum. And the subdued performance of business investment is in large part driven by the uncertainty that Brexit has resulted in. We may not be in the recession that many economists had predicted before the vote, but make no mistake, Brexit is a drag on economic growth.
With regards to the future path of UK interest rates, last month’s MPC decision adds a bit more uncertainty around what will happen next. But I still think we will see one rise this year.
Economic growth is unlikely to remain as weak as it was in the first quarter throughout the whole of 2018. The UK labour market remains strong, with wage growth ticking up slightly. And, as I’ve said above, interest rates eventually need to move away from the low levels that they have been at for some years.
The MPC is scheduled to meet again in June, but a rise then is unlikely. I think it will be the second half of this year before a rise could happen, and that a single increase in 2018 to 0.75 per cent is the most likely outcome.
To sum up, the UK economy is going through a challenging time due to Brexit. Given the weakness of the growth numbers for the start of the year, the Bank of England’s decision to hold off on a rate rise in May is understandable. While the challenges facing down the economy are likely to persist for some time yet, a pickup in the quarterly rate of growth is expected as we move through the rest of 2018. And in my opinion, interest rates are likely to go up in the second half of the year.
This article was published in The News Letter on 5th June 2018