The Governor has warned us that a rate rise could happen soon. Markets have duly priced in an increase. The pound rallied strongly against the dollar, partly on that interest rate expectation. UK ten year rates and other longer term bond yields have adjusted upwards.
The problem is that the economy is slowing. Treasury policy has reduced activity in the homes and cars markets and the Bank has already tightened monetary conditions substantially. The Bank of England has sent clear instructions to commercial banks to go easy on consumer credit, rein in car loans and to be careful with some mortgages. This is having a depressing effect on output. Chancellor Osborne deliberately hit the Buy to Let market with strong tax rises in his March 2016 budget, and reduced activity in the top end of the housing market with higher Stamp duties. Chancellor Hammond hit the dearer end of the new car market with his high Vehicle Excise duties in March 2017. He was assisted by other Ministers in undermining interest in buying new cars by statements that diesel and petrol cars will be phased out over the longer term. Diesels were particularly badly hit as they attracted the most criticism for their emissions, leaving potential purchasers worried about second hand values.
The latest Construction PMIs (Purchasing Managers Index) are also worrying. Whilst these are in part forward looking opinions which can prove inaccurate, they do also capture order input. Orders for civil construction work are very weak, and commercial work too has been disappointing. The civil construction work is poor partly because the government is not signing up to a new generation of infrastructure projects quickly enough to replace the work on current contracts as they complete. It is something the government could fix but so far has not been able or willing to do. Commercial work is weak because the leading Real Estate Investment Trusts and other commissioners of new offices and shops are pessimistic about future demand levels for space and so have decided to restrict new supply.
It does not normally raise rates when the economy is slowing and the recent recorded growth rate is sluggish
All this poses a major dilemma for the Bank. The Bank says it is data driven. It does not normally raise rates when the economy is slowing and the recent recorded growth rate is sluggish. It is true inflation has gone above target, but there is little evidence to suggest it is going to rise next year, with no visible follow through in wage growth so far. Previously the Bank saw the inflation rise as temporary and correctly decided to look through it when they and other external forecasters expected it to rise. If the Bank does not increase rates it will be criticised by some for the misleading signal it has given, and the pound may suffer a bit. If it does increase rates when the data does not justify it, it may do more damage to confidence and output.
It does have third way options. It could relax its monetary tightening by revisiting its tougher credit standards and banking controls as an offset to the increase in rates. This seems unlikely, as the Bank is clearly in hawkish mode on bank lending. It could go ahead with a 0.25% hike but lace it with dovish language to say that it had removed the emergency cut of the summer of 2016 but saw no need for further rises anytime soon. This might blunt some of the adverse effects of a rise.
All this makes predicting the Bank’s actions very difficult. Maybe the rate rise most expect is not a racing certainty. What is easier to predict is weak growth for the UK if the Bank follows up its monetary tightening through toughening credit rules and a higher pound with a rate rise. At a time when the European Central Bank is doing everything in its power to extend and strengthen the recovery in the Euro area economy and the Japanese Central Bank is also very accommodative, the Bank of England seems to be doing the opposite. All this is a headwind for UK shares.
The above article was first published by Charles Stanley on 6th October 2017