Business

Market expecting first rate hike in early 2015

THE August meeting of the Bank of England's Monetary Policy Committee (MPC) marked the first time under governor Mark Carney that there has been voting dissent within the Committee. The dissent was in the form of two (McCafferty and Weale) of the nine members voting for a rate hike.

A key dilemma and source of uncertainty/disagreement in the MPC's policy deliberations is the conflicting signals over the degree of slack in the labour market. The concept of 'spare capacity' in the economy is the basis of the bank's current forward guidance on interest rates. On the one hand, the economy has recorded very strong job growth, with a marked fall in unemployment. On the other hand, wage inflation remains very weak. As a result, a "wide range of views" exist within the MPC on the extent of the spare capacity remaining in the economy.

The voting 'hawks' were of the view that the estimates of the degree of slack in the economy were "becoming a somewhat less informative guide to the appropriate future path of monetary policy". Instead, "economic circumstances were sufficient to justify an immediate rise in the Bank Rate". However, for the majority of the MPC, there "remained insufficient evidence of inflationary pressures to justify an immediate increase in the bank rate". They were also concerned that a "premature tightening in monetary policy might leave the economy vulnerable to shocks".

It is not only the two votes for a rate hike that indicate that the MPC is becoming more hawkish. The MPC is taking increasing encouragement from the strong performance of a raft of economic indicators. At the August Quarterly Inflation Report (QIR) press conference, Governor Carney noted that the "expansion is on track and sustained economic momentum is looking more assured" with the economy "returning to a semblance of normality".

However, while is it clear that the BoE is moving closer to the point where it will start to hike interest rates, what is less clear is the exact timing of this. Prior to the release of the August Inflation Report, the market had been moving towards pricing in the first rate hike before the end of this year. However, the most recent QIR seemed to push out the timing into Q1 of next year with Governor Carney suggesting that low wage growth may delay rate hikes by stating that the MPC will be "placing particular importance on the prospective paths for wages and unit labour costs".

Since then, in a more recent newspaper interview, the governor has muddied the waters somewhat by commenting that rates may have to rise even before there is a pick-up in real wages.

Overall, given the content of the August QIR and meeting minutes, as well as the fact that the inflationary environment remains relatively subdued, the market is pricing in that the first rate hike will occur in quarter one of 2015 rather than before the end of 2014.