August 4, 2017

News in Charts: UK MPC tries to have its cake and eat it

by Fathom Consulting

On Wednesday, we presented an overview of our Global Economic and Markets Outlook for 2017 Q3. The focus of the event, which was hosted by Thomson Reuters in London, was the UK economy, for which Fathom’s outlook is considerably more pessimistic than most. We were joined by former Bank of England policymakers Sir Charlie Bean and Sir John Gieve, both of whom share our concern about the UK’s deteriorating growth prospects.

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In our view, with the Bank of England’s Monetary Policy Committee having failed to pull the trigger at this week’s meeting, and with economic growth set to soften further through the second half of this year, Bank Rate will be on hold more or less indefinitely.

But this did not stop the Committee from trying to have its cake and eat it. It voted not to tighten policy at a time when inflation was significantly above target, and was expected to remain so for the duration of the Bank’s forecast horizon, while simultaneously trying to persuade investors that they had failed to price in a sufficiently aggressive policy tightening.

But having made that same complaint last quarter, and with more hawkish rhetoric from several members having falsely motivated expectations of a potential rate hike, markets have grown wise to these siren voices and have ignored the Bank’s message. Sterling closed Thursday down 0.6% against the US dollar, while the gilt curve flattened.

On Wednesday, our panellists and audience concurred that the Bank of England was unlikely to raise rates this week. John Gieve considered there to be a strong case for reversing the post-Brexit cut, but considered it unlikely. 23% of Wednesday’s audience agreed, while 44% felt that Bank Rate would be increased within one to two years on the back of improving economic growth momentum. Others, accounting for almost a third of our audience, considered it to be only a matter of time before a majority forms and Bank Rate is hiked.

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However, our analysis of past episodes of dissent reveals that, more often than not, since the Bank was granted operational independence in 1997, those voting for a hike have given up or left the Committee. In fact, with a success rate of 75%, a majority is far more likely to form behind those pushing for a rate cut! In addition, as our chart highlights, it is not the first time that the Committee has looked through above-target inflation, with the relationship between consumer price growth and rate decisions surprisingly poor.

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The optimism expressed by those that considered a rate hike to be on the cards was also reflected in their answers to our first question, with a majority (64%) deeming it more likely than not that the UK would avoid recession within the next year. That being said, at 36% a surprisingly high proportion sided with us, believing that there is a greater-then-evens chance of a contraction ahead.

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This was a concern shared by our panellist, Charlie Bean, although he said that trying to predict a recession is a “mug’s game”. He is right. With trend growth now significantly weaker, at around 0.3% a quarter in our view, the prospect of dipping into negative growth at any point in time has risen. It is for this reason, and with households under the cosh, that we think there is a greater-than-evens chance of recession.

At Wednesday’s event, Fathom’s Managing Director Erik Britton set out our view on the UK economy, which we have shared with clients in a series of presentations over the past few weeks and in a recent Newsletter. In summary, the UK consumer weathered the Brexit storm better than the majority of forecasters, ourselves included, anticipated. The broad-based failure to predict the strength of consumer spending has been rationalised in numerous ways, but the most persuasive explanation is that households were surprisingly rational, bringing forward expenditure in anticipation of sterling weakness ahead.

Unfortunately, such an explanation carries ominous connotations for an economy dependent on the consumer for growth, as reflected in the data for the first half of this year. Looking ahead, we believe that there is now a greater-than-evens chance of a technical recession in the UK over the next twelve months. We take that view for several reasons. Not only are wages failing to keep pace with the rising cost of living, resulting in an erosion of consumers’ real purchasing power, but household finances are already stretched — as indicated by the household savings ratio having slumped to its lowest level since the 1950s.

Having already dipped into their savings, which a recent survey commissioned by the Bank revealed to be consumers’ preferred means of preserving real consumption, there is little to cushion consumers from the intensifying squeeze ahead. Indeed, we see inflation peaking at 3.2% later this year. Recognising that highly indebted households are more sensitive to changes in their financial situation, official bodies have also threatened to crack the whip if banks do not tighten their lending standards. They may not need to.

Only a small proportion of those surveyed (4%) said that they would rely on additional bank credit to shore up spending, and it is not uncommon for households to spend less and save more in periods of heightened uncertainty. In the past, as our chart highlights, a deterioration in consumer sentiment has been a good predicator of slowing household consumption growth. Notably, June’s inconclusive general election appears to have reignited concerns about the nation’s economic and political prospects.

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Both panellists, Charlie Bean and John Gieve, agreed with Fathom that neither investment- nor export-orientated growth was likely to save the day. One reason for this, as highlighted in the chart below, is that exporters have increased the sterling price of their exports by nearly the same amount as the fall in sterling over the past year. Having broadly maintained the price in foreign currency terms, UK exporters have been able to build their profit margins, albeit at the expense of growth in volumes. As Charlie Bean highlighted, this increase in profits would normally promote investment in export capacity, feeding through to the UK economy via this mechanism as opposed to net trade. But with Brexit-related uncertainty likely to weigh on firms’ investment plans, this is unlikely to feed through as hoped.

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As a consequence, and “given we are starting from a position where the saving ratio is unusually low”, Charlie Bean concluded “that it is not impossible to think you might get quite a sharp slowdown.” Wednesday’s audience echoed this concern. As our chart shows, when asked to vote the majority chose “further falls in real household incomes as prices continue to rise” as the most likely trigger for a UK recession.

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