In less than a year financial markets have been told by the BoE in Aug 2013 that they were too hawkish in expecting rate hikes, then in Feb 2014 that they were right to expect a hike in 2015 and this month that they were too dovish in not pricing in the risk of a hike this year. At each juncture the BoE has managed to surprise the market and the direction of travel toward a more hawkish BoE begs the question why not hike in August?
There are three reasons why the BoE is unlikely to hike as early as August. Firstly, the BoE needs to communicate why it intends to raise rates, what this means for the outlook and the speed/destination of interest rates as the tightening cycle begins. On the latter the BoE would prefer to use the more comforting phrase ‘normalisation’ as this is less likely to cause stress over the outlook. The hope is that such communication will lead households and firms to prepare themselves which is likely to require more than just 2-3 months.
Second, the BoE will want to strengthen its “gradual and limited” script as well as reveal more information about how QE will fit into the normalisation puzzle. There will come a point in the rate cycle at which the BoE will want to reduce its holdings of QE related gilts. This will likely lead to an effective tightening of monetary conditions as there will be less liquidity to play with. How fast the BoE intends to exit from QE will be an important input into the normalisation script.
Lastly, there is the economic data itself and importantly the evolving views over spare capacity. Even as spare capacity estimates move lower and the BoE gets closer to its goal we could see inflation move lower. Another round or price cuts by the major supermarkets in the UK as well as the China slowdown story will help to keep a lid on inflation. We see a significant risk that inflation will fall below 1% this year and this could severely impact the rate cycle dynamics.
The risk of a rate hike in August is low with our central scenario being for the first hike to come in November. Subsequent rate hikes will come quarterly and likely delivered in Inflation Report months of Feb, May, Aug and Nov during 2015.