Interest rates: “So, on one level the anticipated move is a sign that we are slowly leaving the legacy of that period behind.”

by | Aug 2, 2018

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Bank of England

Russell Silberston, Head of Multi-Asset Absolute Return, Investec Asset Management: “Whist sounding modest, today’s 0.25% rise to 0.75% will put official interest rates back to the level prevailing in February 2009, when in the midst of the Global Financial Crisis, the Bank of England reduced Bank Rate from 1% to 0.5%. So, on one level the anticipated move is a sign that we are slowly leaving the legacy of that period behind.

“However, the UK is now a very different economy to the one that prevailed on the eve of the GFC, with lacklustre economic growth, a strong labour market and low productivity. So why are the Bank of England contemplating tightening monetary policy? The answer lies in the supply side of the economy rather than the demand side on which markets and commentators usually focus.

“The supply side can be thought of as our economic speed limit and in recent years this has collapsed to approximately 1.5% per annum from 2.0 to 2.5% per annum. There are many reasons for this fall, but the collapse in productivity, centred on manufacturing and financial services is one of the key drivers. This lower speed limit implies that even with modest economic growth, spare capacity will be used up more quickly, heightening inflationary pressure. This lack of capacity, and danger of higher inflation is the key motive behind the Bank’s actions, in our view.”

 Update to Bank’s view on neutral rates points to medium term expectations

 “Another interesting angle in this meeting, beyond the anticipated hike and accompanying Inflation Report forecasts, is an update to the Bank’s view on the level of UK neutral interest rates. This is the level of rates that is compatible with trend growth and inflation at target. Unlike the Federal Reserve, the Bank has not until now formally communicated their assessment of this rate.

“We think of this rate as a medium term interest rate that prevails in the medium term, best expressed as a 5 year rate, 5 years forward. Based on current pricing, this is currently 1.8%. We believe this is likely to be too low, with the well-known Laubach & Williams model suggesting a nominal rate of 3.5% and a previous Bank of England blog suggesting 2% back in 2015. However, the latter work was conditioned on much tighter financial conditions than prevail currently.

“The Bank have now pitched neutral nominal interest rates closer to 2.5%. This suggests longer dated gilt yields, which show a high correlation with 5 year / 5 year rates to shift significantly higher over the coming months.

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