Bank of England and the next rate increase

by George Hatjoullis

The BoE formal mandate remains the inflation target. The inflation target is 2%. However, interest rate policy is not driven by the current inflation rate but by the likely inflation rate over the forecast horizon. Monetary policy, it is believed, operates with a lag and thus decisions today affect inflation some months forward. The accepted wisdom is that the lag operates up to 2 years forward, so monetary policy is tricky to operate. Monetary policy is related to the information contained in the quarterly inflation report. This gives some insight into the current thinking of the BoE. Any rate increase will almost certainly coincide with (just before or just after) and inflation report showing that the likely inflation rate over the forecast horizon is above the target. Presently the inflation rate is just below the target.

The inflation report is based upon the BoE’s econometric model of the UK economy. Anyone with a postgraduate degree in econometrics will have an idea how flaky these models are and how much ‘manual adjustment’ is required. They will also know which variables appear and what weight they are given. Two very important variables are the rate of change of nominal wages and the rate of change of sterling. In order for this model to spew out some inflation warning, the outlook for wages needs to be positive and for sterling to be negative. At the moment nominal wages are flatlining and sterling looks strong. It is quite hard to conjure up an inflation threat in this context even with creative manual adjustment.

The wage situation is obviously puzzling Carney. Unemployment is falling yet nominal wages are barely responding. In part this may be temporary and reflect deferred bonuses for tax avoidance reasons (I thought this was illegal). If this is so then we shall soon see the wages time series jump up again. The other possibility is that falling unemployment is a poor measure of labour slack. It may be that changes in unemployment insurance are removing people from the statistics without providing adequate employment opportunities. This may be reflected more zero hours contracts, self employment and black economy activity. All could depress nominal wage measures. The drop in unemployment is thus partly an illusion. The other possibility is that UK employment is experiencing what i like to call job degradation. Technology changes are creating progressively more and more low paid jobs and very high paid jobs. The former are more numerous and the middle ranking earners are being forced into lower paid jobs. The average is thus biased downwards as job degradation progresses. What ever the reason Carney will struggle to come up with an accommodating inflation forecast unless nominal wage growth is expected to pick up and it may be hard to justify such an assumption.

Sterling is more fickle. The strength of any currency is hard to rationalise. It is not hard to forecast, just hard to rationalise. There is no particular reason to expect sterling to weaken very much from current levels and there is good reason to think it will strengthen further. This view is not difficult to come up with and hold with some confidence. Telling a convincing story that people understand and find plausible is much harder. Having spent a career making the forecast and then inventing plausible stories to persuade people, I could have a go. However, i have retired and cannot be bothered. Suffice to say that sterling is not going to help Carney conjure up an inflation justification for an interest rate increase.

So what will happen to interest rates? There has to be a rate increase either just before or just after the next inflation report. Any later and it comes within the May election focus. The next inflation report is in November, so the rate increase will be between October and January. The rate increase will be 10bp. If the inflation forecast cannot be cooked it will be justified as precautionary and there may be some mumbling about the housing market or some such excuse. It will be accompanied by quite a lot of forward guidance about a slow pace of increase and a historically low exit level at which the rate increases will cease.