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Thursday, February 11, 2010
With base rates now held steady for 11 months, The Bank of England's Monetary Policy Committee (MPC) voted last week once again to hold base rate at 0.5% and to hold its asset purchase programme at £200bn. The halt to QE had been widely expected, and financial markets were largely unmoved by the announcement. The statement accompanying the decision was also very much as expected. The MPC noted that there had been some, albeit tentative, signs of recovery in activity and it expected the recovery to proceed gradually, impeded to a degree by tight credit conditions and the need for further measures to strengthen balance sheets in the public and private sectors.
What next for the economy?
The debate will now shift towards the question of when the MPC will begin to raise rates. In its November 2009 Inflation Report the MPC projected that inflation would be above target and rising in two years' time if policy were held on its current setting and the markets expect a similar projection in the February Inflation Report, which is due to be published on Wednesday 10th February. That being the case, the only reason for keeping policy ultra-loose is a concern about the strength of the recovery and the worry that the economy might relapse into recession. By the middle of the year current city forecasts are that the economy will have shown more convincing signs of growth, persuading the MPC that the current "emergency" policy stance is no longer needed.
So where might base rate be heading?
In a recent poll of 66 analysts across all the major banks in London the median forecast saw rates staying at 0.50% until August/September 2010 before rising to 1% at the year end. Looking forward into 2011 the median forecast saw rates rising further to end the year at 2% - 2.25%.
It's worth noting though that there is some divergence of views within these averages. Respected names such as BNP Paribas, Lloyds Group and Standard Chartered hold the view that rates will not be above 1% by the middle of 2011 whilst others of similar standing, such as Barclays Capital, Deutsche Bank, Goldman Sachs and HSBC, see rates at or beyond 2.50% by the same point.
Much of this divergence of view rests on the continuing recovery of the patient that is the UK economy. At the moment that recovery appears very fragile, credit supply remains highly constrained and nominal spending is weak. If there were to be no material acceleration in activity in H1 we think it highly likely that the MPC would consider a further sizable expansion in QE with an increase in base rate deferred till 2011. Regardless of when rates start to rise those with borrowings linked to LIBOR rather than Base rate will feel the pinch first as markets begin to price in increases to come.
Valiant Consulting Limited
Valiant Consulting provides bespoke professional advice to clients on the management of their Foreign Exchange and Interest Rate Risk issues. If you would like to discuss any aspect of financial market risk management with the team then the initial assessment is free.
A Postscript ...
Since Mike wrote the piece above he has sent me an update ...
Since we wrote this piece the BOE has published its quarterly inflation report. In reviewing the content of the report and the comments that accompanied it from the Governor the markets have shifted their expectation on when the first base rate rise might be. It's fair to say that those who were expecting a 25bp increase in August are now thinking more along the lines of November and that many others have shifted their expectation towards no increase in the next 12 months.