BoE Policy Unchanged – Negative Rate Debate Rages

David Page, Head of Macro Research at AXA Investment Managers | The Bank of England’s Monetary Policy Committee returned to harmony as it unanimously voted to leave monetary policy unchanged today. Bank Rate was left at 0.10% and the asset purchases facility was also kept unchanged at £745bn. Minutes to August’s meeting suggested that risks to the Bank outlook remained “skewed to the downside”. It added that “different members placed different weights on the nature and scale of these risks” – a natural outcome in what the Bank considered “unusually uncertain” conditions. However, this was the only colour provided on different views across the Committee.

The BoE published its August Monetary Policy Report. Unlike in May, this Report returned to more conventional projections – albeit with the health warning that elevated uncertainty meant that its “medium term projections were a less informative guide than usual”. Against a backdrop where outcomes in international economies had been “significantly stronger than in May”, the Bank produced domestic forecasts that were firmer than the scenario it had discussed in May. Specifically the MPC considered June’s monthly GDP likely to rise by 9% m/m, which it said would deliver Q2 GDP at -21% q/q. The MPC forecast GDP to Q2 2020 from Q4 2019 would fall by 23%. However, it also said that the rebound in activity had been strong, although uneven since the trough. It forecast GDP for the year as a whole contracting by 9.5%, before posting growth of 9% in 2021 and 3½% in 2022. This profile is consistent with UK output recovering 2019 levels by the end of 2021. It would also result in spare capacity in the economy being removed by 2022, when modest excess demand would emerge – albeit that this outlook also reflected the BoE’s expected evolution of supply conditions. Thee BoE also forecast that CPI inflation would fall to around ¼% by year-end – a drop exacerbated by government stimulus measure including the partial VAT reduction. However, the BoE envisaged most of this being unwound next year and forecast a return of inflation to target in 2022 – underpinned by its assessment of spare capacity. The Bank forecast CPI inflation at 0.25% end 2020, 1.75% end-2021, 2.0% 2022 and 2.2% in 2023.

The MPC considered the risks around this outlook as skewed to the downside, with the uncertainty around the virus itself leaving the outlook more uncertain than usual. The details of the forecast discussed a number of uncertainties over labour market statistics, including some of the apparent inconsistencies in the number of employed reported rising 97k in the 3-months to May, but employee payroll dropping by 650k March to June. The BoE considered sampling problems as one consideration here. The BoE forecast unemployment rising to 7.5% by Q4 2020, but beginning to fall from here to 6.6% by this time next year, 4.7% in two years’ time and 4% in three. This affected the outlook for consumer spending. The BoE reported data suggesting a sharp rebound in consumer spending, although the outlook would remain dependent on the labour market and consumer confidence, which would effect levels of savings. The BoE also suggested that investment was expected to recover in a more subdued fashion than consumption, reflecting elevated uncertainty and financial conditions. BoE Agents Reports were consistent with a more cautious outlook for investment, with investment intention currently falling further.  

The Report also discussed the policy outlook. While there was unanimity that policy remained appropriate for now, the Report provided some detail on the Bank’s consideration of future policy changes, including the possibility of lowering Bank Rate further to negative territory. The Report stated that the “MPC regularly reviews evidence about whether cutting interest rates further could  provide additional stimulus to the economy in an effective way” particularly relative to other tools, emphasising that it was “currently considering” this case. The Bank said this decision would in part reflect the structure of the financial system and in part the financial and economic conditions at the time. With the former it explained that reservations surrounded evidence that though negative rates lowered most market rates, the transmission to household deposit rates tended to be “attenuated”. This risked impacting commercial banks’ balance sheets, already negatively affected by the pandemic. This meant that negative policy rates “at this time” could be less effective, although the Report conceded that there were measures the Bank could do to alleviate these issues. The Bank concluded that it “will continue to review the appropriateness of negative rate policy as a policy tool alongside its broader toolkit”. This, of course, fails to resolve the BoE outlook on this issue and will leave it a matter of debate in financial markets over the coming months and quarters.  

August’s BoE outlook marks greater convergence with our own outlook than in May. In contrast to that time, we are now modestly more pessimistic for overall economic activity than the BoE. Although we forecast Q2 GDP falling by 20% q/q, our outlook for 2020 as a whole is a weaker -10.7%, implying a materially weaker outlook for H2 2020 – although we fully acknowledge the considerable uncertainty that surrounds precise forecasts. We forecast UK unemployment rising to 8.5% in Q4.  In part because of a weaker H2 2020, but in part because of a more cautious assessment of the impact of the government’s choices around ending Brexit transition, we forecast a more subdued 2021, expecting GDP growth of 7% compared with the BoE’s 9%. This leaves us expecting GDP to recover 2019 levels only in 2022, with excess supply expected to persist for longer than the BoE forecasts. As such, we forecast UK CPI inflation as likely to remain below the 2% inflation target for most of 2022.

This affects our policy outlook. We think it likely that the BoE will provide additional stimulus over the coming quarters, however, for now envisage that to be more ‘conventional, unconventional’ policy including forward guidance and additional QE, which we forecast rising by £75bn in November. We believe that the relatively fast turnover of UK mortgage debt (fixed rates in the main around 2-5 years) compared with European counterparts, makes the UK banking system more vulnerable to negative interest rate policy. We do not expect Bank Rate to be reduced into negative territory. However, we do consider the prospect of Bank Rate being reduced to 0.0% and the TFSME scheme being adapted to provide funding to the banking system at rates below the Bank Rate – similar to the ECB’s TLTRO programme. We see the likelihood of these outcomes being tied to two key issues. First, on the prevailing level of gilt yields. In recent days 10-year gilt yields have reached all-time lows of 0.06%. At these levels, we argue there is little scope for QE to provide additional stimulus, with rates unlikely to move materially below the expected lower bound of the policy rate level. In this instance a technical adjustment to the TFS would allow gilts to trade at lower yields and provide more policy space for QE. However, if global yields have started to rise – as we expect modestly by year-end and beyond – the scope for traditional QE to keep policy yields lower will be higher. Second, whether the BoE believes further stimulus is warranted – hence we see this largely as a decision for H1 next year, particularly in the wake of the virus developments over the winter and the UK’s ending of transition. On balance, we think the BoE will provide additional QE in November, but will not provide further stimulus thereafter.

Financial market reaction was guarded. 2-year and 10-year gilt yields initially rose at the open by 2bps, but 2-year retraced these moves back to flat and the 10-year yield is currently 1bps lower at 0.12%. However, sterling firmed on the announcement by 0.2% to the US dollar and 0.5% to the euro.