Having initially formed its forward guidance on interest rates around unemployment, the Bank of England switched tack when the fall in unemployment happened far faster than expected.
Forward guidance mark 2 arrived in February this year when the BOE turned its focus on to the concept of slack in the economy as one of the deciding factors on when rates would start to rise. It identified that there was spare capacity in the economy, thus indicating that the economy could grow at a faster rate without requiring an increase in rates.
The Bank has now stated that some of the slack in the economy has been used up, but that there was actually been more of it than it first thought. It led to the Governor Mark Carney admitting that there is tremendous uncertainty on slack and so the Bank has now placed wage growth on the table as another key decider on when rates should rise.
The continual moving of the goalposts on forward guidance during 2014 led to confusion over the outlook for UK rates. By August the steady increases in GDP had moved expectations of a base rate hike to late 2014 or early 2015. In the last month however, both the UK Government and the Bank of England have acknowledged that the slowdown in Europe may affect the UK recovery and this, combined with an inflation rate that has dropped to 1.2%, a lack of pressure on wage increases and an oil price that has been falling since the summer means that UK rates may now stay lower for longer.
The Office for National Statistics (ONS) reported in October that the Consumer Prices Index (CPI) inflation had dropped to 1.2 per cent in September, compared to 1.5 per cent in August. The ONS said that inflation was dragged down by food and fuel prices and if these were removed inflation would be a third higher.
The overall growth in the UK Economy is still robust at 0.7% for Q3 and 3.0% year on year despite weak demand from the Eurozone, however as the Eurozone accounts for 50% of UK exports, maintaining growth in the UK is now seen as dependent on growth picking up in Europe as well as domestic demand.
In the November release of the BOE Inflation Report, the dovish tone dramatically changed expectations on interest rates from the previous report in August.
In the Inflation report, Bank Governor Mark Carney put the spotlight firmly on low inflation while also focussing on weak wage growth and continued slack in the economy.
He once again declined to be drawn on the exact timing of the first rate rise, but reiterated that when rates did start to rise the move would be slow and gradual.
The graph shows the change in rate expectations caused by the November report. The expected timing of the first UK base rate rise has now moved to Q3 2015, after the General Election in the UK in May. Further increases are also seen to be gradual with the futures now predicting that the base rate will only reach 1.75% in three year’s time, down from the expectation of 2.25% in August.
In the US figures released in November confirmed that the US economy had grown by 3.9% in Q3 and this, combined with the Q2 increase of 4.6%, shows that the US economy has seen its fastest six- month growth period since 2003.
October also saw the ending of the US QE bond buying programme which began six years ago to give support to the financial system. The end of the $4.5 trillion programme signals that policy makers at the Fed are now comfortable that there has been a substantial improvement in the US labour market and that there is sufficient underlying strength in the broader economy.
Despite this news the Federal Open Market Committee (FOMC) – the Fed’s policy setting committee – reiterated its commitment to leaving rates on hold in the coming months, ignoring the brighter economic backdrop.
In the minutes from its October meeting the FOMC sounded an optimistic note on the economy, suggesting recovery was on track with economic activity expanding at a moderate pace. Committee members pointed to falling unemployment, rising household spending and increased business investment.
Economists are currently left divided on the likely timing of the first rise in US rates with opinion ranging between Q1 and Q3 2015.
The growth in the UK and US conflicts sharply with the Eurozone where growth was only 0.2% between July and September. The OECD predicts total euro zone economic growth at 0.8% this year, which is better than the economic contraction suffered in 2012 and 2013, but below average growth of 1.1% between 2002 and 2011.
Despite the last cut in Euro rates in September and the beginning of the asset back securities and covered bond programme in October the European Central Bank (ECB) has announced that it is also ready to buy government bonds if inflation in the Eurozone fails to rise as anticipated.
The ECB’s attempts to boost growth in the Eurozone are seen by some as too late and that there is a danger that the Euro economy could follow Japan and see years of stagnation.
The negative interest rates that now exist in the short end of the Euro curve have not sufficiently weaken the Euro currency thus far to initiate an export led recovery and so the ECB is left with few options but to follow the US and UK examples and reflate the economy through QE.
Eurozone rates are currently not predicted to rise for at least 3 years.