Investment - Articles - Stronger UK growth equals earlier rate hike


 Schroders' European Economist Azad Zangana comments:

 "The UK seems to be operating in a much higher gear than the rest of Europe, leading us to revise up our forecasts for growth, and bring forward our forecast for the first rise in interest rates

 "The UK economy continues to perform very strongly, in particular, strong growth in household consumption and more recently, business investment. Slight upward revisions to growth in 2013, along with an upside surprise compared to our forecast for the first quarter, has led us to conclude that there is stronger momentum in domestic demand than previously forecast. Households have been reducing their savings rates to expand consumption, despite falling real disposable income. The recent fall in inflation is helping to moderate the squeeze, but ultimately, the household sector seems to be happy to increase its leverage once again.
 "This might be explained by the recent sharp fall in the unemployment rate, which fell to 6.8% over the first quarter, compared to 7.2% in the previous quarter, and 7.8% a year earlier. Indeed, consumer confidence has also been very strong, with the GfK survey recording confidence in May returning to highs not seen since 2005.

 "Overall, it appears that in the absence of serious fiscal consolidation this year and a willingness of households to borrow once again, domestic demand in particular is likely to be stronger than previously forecast. We have therefore raised the 2014 growth forecast from 2.6% to 2.9%, and from 2.1% to 2.4% for 2015. Supporting this is the downgrade to the inflation forecast for the UK, partly due to a change in assumption on GBP (smaller depreciation), but also on the back of lower near-term pressure from food and energy price inflation.

 "Stronger growth raises the prospects that the Bank of England may raise its policy interest rate sooner than expected. While inflation in the near term remains benign, the Bank is considering the profile of future interest rates. The debate seems to be heading towards the notion that an earlier start to the hiking cycle will allow the BoE to ease the squeeze on the household sector by hiking more slowly. Macroeconomic theory points to the importance of the level of interest rates for long-term economic growth, but in the short-term, the change in interest rates is more important. Therefore, the BoE should take as much time as possible in normalising rates.

 "This debate has been highlighted in recent interviews by Martin Weale, an external member of the BoE's monetary policy committee. As the Bank forecasts the output-gap to be closed by around mid 2017, in theory, it should want to 'normalise' interest rates by then. The first question that arises is what the new equilibrium rate actually is. In the past, 4 to 4.5% seemed to be the preferred neutral rate, but the Bank has strongly signalled that this is now too high post the financial crisis. Not only is trend GDP growth expected to be lower, but there is an argument that prior to the crisis, banks were not charging enough of a premium (spread) over the Bank's risk free rate - implying that lending risks were being underestimated. If lenders are now charging more appropriate premiums, then the Bank of England can achieve the same effective interest rate (true average interest rate charged to households and corporates), but now with a lower base rate.

 "In our view, the Bank is likely to remain very cautious and will look to raise interest rates by no more than 25 basis points each quarter. Even Weale - a more hawkish member - agrees with this pace of tightening. He may start to call for rate increases in the near future, but we forecast the BoE to remain on hold until August 2015. The market is pricing in a strong chance of the first rate rise by February 2015, and at least the first rise by May 2015. As the next general election will be taking place at that time, in our view, it would be strange for the BoE to introduce additional market uncertainty by raising interest rates. We think August 2015 is therefore more likely."

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