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RATE EXPECTATIONS BY NEIL WOODFORD

24th June 2014

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24 June 2014, 14:29
Written by Neil Woodford

The Governor of the Bank of England, Mark Carney, got himself in a bit of a pickle with his policy of forward guidance. Originally introduced when he arrived from Canada in July 2013, the intention was to provide the market with greater clarity on the likely future path of interest rates and the conditions that would necessitate the start of policy tightening.

In February, however, with unemployment having fallen faster than anticipated, the policy was abandoned and Mark Carney today faced questions from the Treasury Select Committee about the continued confusion around the evolution of the UK’s monetary policy.

Mark Carney’s latest speech at the Mansion House on 12 June, led the market to expect that the first hike in interest rates would come much sooner than previously expected but I am not so sure. Admittedly, Carney’s remark, “There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect”, does seem to vindicate the market’s viewpoint. However, this statement was followed immediately by the more nuanced, “But to be clear, the MPC has no pre-set course. The ultimate decision will be data-driven. At this point it is safest to conclude, as the MPC has, that there remains scope for spare capacity to be used up before policy is tightened and that a host of labour market, capacity utilisation and pricing indicators should be watched closely to determine how that slack is evolving.”

I believe the second half of this part of the speech has been largely overlooked by the market but it is really important. The Governor is pointing to three reasons why interest rates may not need to rise in the near term, or indeed for that matter, in the medium term.

Firstly, regarding the labour market, whilst the recent strength in employment figures has given some commentators the impression that an interest rate rise is now required, it has not yet resulted in a pick-up in wage inflation. If it were to do so, I would agree that an interest rate rise would become much more likely. However, I do not expect a pick-up in wage inflation because, as the chart below illustrates, much of the growth in UK employment has come from self-employed workers. Individuals in self-employment do not tend to have as much pricing power as employees of larger organisations or unionised work forces that can aggregate to improving their bargaining position. In fact, it is plausible that the growth in self-employment actually represents a workforce pricing itself back into work, rather than one that is strong enough to be on the verge of stimulating a rise in wage inflation.

2014 06 self-employed

 

 

 

 

 

 

 

 

 

 

 

Secondly, there is a degree of spare capacity in the labour market and elsewhere in the economy which reduces the need for an imminent increase in rates. Spare capacity is very difficult to measure accurately but economists have tended to use the unemployment rate or the labour market participation rate as a rough proxy. To do so in today’s context would ignore the fact that the shape of the labour market has changed. This is evident in the chart above and the chart below, showing the proportion of part-time workers seeking full-time employment. This figure increased significantly in the financial crisis and has thus far shown only tentative signs of retreating. This suggests that a proportion of the workforce is under-utilised and explains why productivity data for the UK economy has continued to disappoint. For example, the UK economy will produce more or less the same amount of output in this quarter as it did in the first quarter of 2008. However, it will employ around 1 million more people to do so. The Monetary Policy Committee (MPC) appears minded to see spare capacity absorbed by the economy before tightening monetary policy. This may take some time, depending on how productivity and real incomes perform going forward.

2014 06 part-time seeking

 

 

 

 

 

 

 

 

 

 

 

Thirdly, pricing indicators do not suggest an increase in increase in interest rates is warranted. At 1.5% Consumer Price Inflation (CPI) is below the Bank of England’s 2% target and the chart below suggests inflation continues to trend downwards.

2014 06 CPI

 

 

 

 

 

 

 

 

 

 

 

As far as I’m concerned, these are all reasons why interest rates may not rise in the near term. But the fact is, I do not know when interest rates will rise and neither does the MPC – Carney has effectively said as much.

But I do believe that the market is wrong to expect an imminent tightening of monetary policy and believe that it would be a mistake if interest rates were to rise. The UK economy is still struggling with a substantial consumer debt burden, and Mark Carney himself has recently acknowledged that, “a highly indebted private sector is particularly sensitive to interest rates.”

Increasing interest rates and, in turn, mortgage rates, reduces household disposable income. Darren Winder, a highly respected economist at the Lazarus Partnership, recently suggested that each 0.25% increase in the average mortgage rate would decrease the average household’s disposable income by about 1.25%. Such a policy move would potentially be very destabilising for the UK economy.

Given that the Bank of England these days has a dual mandate to promote financial as well as monetary stability, I therefore think it is highly unlikely that it would endanger the UK’s fragile economic recovery by increasing interest rates any time soon.

The views expressed in this article are those of the author at the date of publication and not necessarily those of Woodford Investment Management LLP. The contents of this article are not intended as investment advice and will not be updated after publication.

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