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It is likely that a number of MPC members will soon vote to tighten policy. A split vote that saw one or more rate setters vote for higher interest rates would almost certainly cause the short-end of the UK curve to steepen, pushing sterling higher, just as it did last year. But analysis of the MPC’s voting record over the past 18 years shows that, more often than not, dissenting voices give up, and fall back into line with the majority, just like they did last year.
Minutes from the July Monetary Policy Committee (MPC) meeting revealed yet another unanimous vote, both for the level of Bank Rate, and for the stock of asset purchases. More newsworthy was the fact that, for a number of members, and putting the international environment to one side, the decision whether to leave interest rates on hold, or to tighten, had “become more finely balanced”. For those members “uncertainty caused by recent developments in Greece was a very material factor in their decisions”.
The meeting took place on 8 July, and since that time the risks of an immediate Greek exit from the single currency have faded somewhat. Those who erred on the side of caution in July may well vote for an increase in Bank Rate as early as next month. But what would a split vote tell us, if anything, about the policy outlook?
Historically we find little evidence that dissenting votes signal an imminent change in policy. Indeed, since Bank Rate was cut to 0.50% back in March 2009, there have been dissenting votes in favour of a rise at no fewer than 19 meetings.
We have analysed the MPC’s voting record since the Bank of England gained independence back in 1997 to determine whether dissenting voices tend to get a majority forming behind them. As our table shows, on more than half of the occasions where one or more dissenters have voted to tighten policy, the dissenters have ultimately given up (or left the Committee). Even if we take into account those occasions when the dissenters, having thrown in the towel, ultimately get their way, we find that minority votes for a hike are informative about the direction of the next interest rate move little more than one half of the time.
Spurred on by this week’s Minutes, and by remarks made by Governor Carney earlier in the month, the point at which an interest rate hike is fully priced in has been brought forward from August 2016 to April 2016. But the MPC has moved markets before, only to disappoint. Indeed, it did so as recently as last summer.
Domestic inflationary pressures rising
Domestic inflationary pressures are rising. The labour market has tightened significantly over the past two years, as stronger demand has run up against stagnant productivity, causing employment to rise sharply and unemployment to fall almost in equal measure. There are signs that this is now feeding through to higher wages. Private sector regular pay growth has picked up markedly in recent months, and is now back at pre-crisis rates.
Our next chart illustrates how, over long periods of time, real wages and productivity move together, but in the short run they can diverge in response to changes in the amount of labour market slack. As the labour market has continued to tighten, real wage growth has moved decisively ahead of productivity growth. Unless productivity responds, this will put upward pressure on domestically generated inflation. In normal times this, by itself, might be enough to provoke a response from the MPC. However, China’s ongoing slowdown means that external price pressures are likely to remain subdued, particularly if, as we expect, the PBoC lets go of the dollar peg.
But economy still vulnerable to higher rates
Our long-held view has been that the MPC will be extremely cautious when raising rates because of the impact that tighter policy will have on the housing market, and on the household sector more broadly. UK households remain highly indebted, with a debt-to-income ratio higher than many of their advanced economy peers. Moreover, the majority of UK mortgage debt is subject to a variable rate, with the remainder often fixed only for a year or two.
Another crucial factor is the growing importance of the buy-to-let (BTL) sector. When the MPC began its previous tightening cycle, back in 2003, BTL investors accounted for around 5% of the stock of mortgages. Over the past twelve years their importance has risen almost threefold. And it is still rising, with BTL investors accounting for almost 25% of new mortgages – close to the peak it reached before the crisis. BTL investors are particularly vulnerable to changes in interest rates. Back in 2013 we warned that BTL investors had become part of the UK’s “zombie population”. The fragile arithmetic that kept them solvent could unravel in an instant once interest rates began to rise. The Financial Policy Committee (FPC) is concerned too (at last). In its latest Financial Stability Report it warned that fire sales by BTL investors may exacerbate a correction in the housing market.
These considerations mean that, in our view, the MPC will keep rates on hold for longer than the FOMC. And when it does tighten, it will do so much more gradually. In the short term, sterling may strengthen a little further against the US dollar, but ultimately we see it falling from here, to as low as $1.26 by the end of next year.
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