Monthly Commentary July 2018
End of an Era
Last Thursday the Bank of England made the decision, in a unanimous vote, to raise the policy rate from 0.50% to 0.75%. Whilst a small change in the policy rate is not, in itself, hugely significant economically, it does represent the end of an era. After all, the last time Bank Rate was this high was February 2009. Since then there have been three General Elections, three World Cups and 6 total eclipses. Mark Carney had only been central bank governor – in Canada – for three months. Gordon Brown was the UK Prime Minister, though not exactly popular. It was, in short, a very long time ago.
Though it may not feel like it, the economic situation has also moved on significantly. Unemployment has fallen from a high of 8.5% to 4%, the budget deficit has fallen from 10% of GDP to 2% of GDP and inflation has gone from 5.1% to 2.4%, via -0.1%.
As usual with Bank of England pronouncements the interesting stuff is in the accompanying statement, minutes and press conference. Firstly, unlike what we are currently seeing from the Federal Reserve in the US, this does not represent the start of a significant tightening cycle; though policy rates may rise further this is “ likely to be at a gradual pace and to a limited extent.” Whilst Google does not offer a translate service from Central Bank to English, it is widely thought that this means roughly one increase per year if the economy develops as expected.
“The MPC reiterated, what is to my mind at least, one of the most important aspects of the post financial crisis economy - the diminished supply side potential of the UK economy. ”Robert Scammell, Senior Portfolio Manager
The MPC reiterated, what is to my mind at least, one of the most important aspects of the post financial crisis economy - the diminished supply side potential of the UK economy. Pre-2008 the UK economy was estimated to be able to grow at 2-2.5% per year whilst still meeting the inflation target. The MPC now believe that this rate has fallen to 1.5% per year and that there is little residual spare capacity in the economy. This means that policy rates have to rise even at the quite low growth rates we have seen recently.
There is another consequence of this phenomenon - interest rates across all maturities are likely to be lower in the future than they have been in the past. Pre-2008 the peak in policy rates could be expected to be between 5%-6% this is now reduced significantly to be between 2%-3%. Those readers who recall policy rates in double digits need to revise their expectations as to what is likely going forward.
Whilst the Bank of England policy rate is of little interest to pension schemes, who have more interest in the long term yields that are used to calculate liability values, there is a linkage. Lower policy rates would typically lead to low long-term yields, so again those who expect long-term rates to rise towards the 5%-6% level we saw pre 2008 probably, again, need to revise their expectations. However it is not all bad news, if policy rates do ever get to 2%, given that 30-year yields are lower than this currently and that yield curves tend to slop upwards that long-term rates can move up from the low levels we have seen. This does not mean they will. Demand from pension funds remains high and any position that seeks to take advantage of rising interest should be appropriately scaled to take into account the risk profile of the scheme.
Source: Bloomberg; Bank Of England interest rate since 2008