Wednesday, June 18, 2014

BOE still needs more evidence slack being absorbed

    Members of the Bank of England's (BOE) Monetary Policy Committee (MPC) need to see more evidence that economic slack is being absorbed before an increase in the Bank Rata is warranted, according to the minutes of their June meeting, a view that was unchanged from May.
    Minutes from the MPC's meeting on June 4 and 5 - when the MPC unanimously maintained rates - also repeated the phrase from the meeting on May 7 and 8 that the policy decision "had become more balanced."
    But the MPC acknowledged that the U.K. economy was starting to return to normal and "part of that normalization would be a rise in Bank Rate at some point."
   However, "the precise timing of the rise would depend on the outlook for inflation," which again would depend on the degree of economic slack, the prospect for its absorption and the broader outlook for wages, the BOE said.
    Since the BOE's May inflation report, there had been little news to change the view that the U.K. economy was on course to meet the MPC's aim of absorbing spare capacity - still seen in a range of 1.0 to 1.5 percent of Gross Domestic Product in the second quarter - over the next two to three years while keeping inflation close to the bank's 2.0 percent target.
     But the minutes also said that there was "considerable" uncertainty among the MPC members around the current level of slack, reinforced by contrasting trends in the economy.
    "On the one hand, output growth had been stronger, and unemployment had fallen faster, than had been anticipated by the MPC and most other forecasters. On the other hand, wage growth and inflation had been weaker. One possible explanation was that the effective labour supply was greater than previously thought," the BOE said.
     The point at which economic slack would be fully absorbed not only depends on its current level, but also the speed at which is is used up. In the May inflation report, economic growth had moderated and productivity growth only recovered gently so slack is being absorbed only slowly.
    However, the minutes also said there was a risk that economic growth would not slow in the second half of the year as expected so the slack would be absorbed more quickly than expected, the BOE said adding that it was "somewhat surprising" that financial markets attached a relatively low probability to a bank rate increase in 2014.
    The minutes said financial markets were fully pricing in an increase in the BOE's 0.5 percent policy rate - unchanged since March 2009 - by the second quarter of 2015 and an analysis of options prices suggest a 15 percent chance of an increase by the end of 2014.
   Once the rate starts rising, market expectations are consistent with a steady pace of increases of around 20 basis points a quarter over the following 18 months of so, unchanged since the autumn of 2013, the BOE said.
    The BOE's forward policy guidance from February also continues to remain relevant, according to the minutes, saying that a rise in the bank rate would only be gradual, given the likely persistence of headwinds weighing on the economy. In addition, the bank rate is also expected to remain below its historical average for some time to come given the legacy of the financial crises.
    Last week financial markets pulled forward their expectations for a BOE rate rise following comments on Thursday by BOE Governor Mark Carney who said the rise in interest rats "could happen sooner than markets currently expect."
    A poll by Reuters released on June 13, the day after Carney's remark, suggest the BOE could raise rates in the first quarter of 2015 compared with a May poll when most economists expected a rate rise in the second quarter.


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