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Hermes comments on the BoE rate hike: MPC may be putting as much store on tactics as strategy

Neil Williams, Senior Economic Adviser, Hermes Investment Management:

“After softer activity data, the BoE's rate-hike today, their second in this cycle, may raise some eyebrows. However, it shouldn't be seen as heralding a swift move upwards.

“As with their first rise last November, the Bank's tone again reflects caution. Suspecting that its room to manoeuvre will become more constrained as Prime Minister May seeks a Brexit Treaty in 2019, it may be putting as much store on tactics as long-term strategy. Even if there is a deal next year, it would most likely only be a precursor to sorting out the various legal and trade systems by December 2020.

“Motivating today's move will be the MPC’s assessment of very little slack left in the economy, and building excess demand. It will also be hoping that spring’s pay settlements data have been strong enough to help validate the traditional link with low unemployment.

“Yet, their window to hike may become smaller in 2019, and even close by 2020. UK growth has almost ground to a halt - from the top of the G5 quarter-on-quarter growth-table in H2 2016 (just after the referendum) to the bottom by H2 2017 - despite a softer fiscal stance.”

Falling short of their 'Goldilocks' rate...

“Moreover, with CPI inflation likely to fall back, the only further hike we expect, to a 1.0% Bank rate, should again be seen as a ‘muscle flex’, rather than the start of an extended tightening. This suggests they will easily fall short of their hoped-for 'Goldilocks' rate of around 2% (or zero in real terms). Unless something else is done, this means there will still be very loose monetary policy for this stage of the growth-cycle.

“In the MPC’s eyes, higher rates gives them more ‘powder’ to use, should the economy slow further. However, this is circular, and the Bank will be mindful that raising rates too far does not cause that downturn!

“To keep the lid on rates, the Bank could in tandem start to whittle away their QE stock. Selling the assets is one for later to minimise the hit to the gilts market. However, as a first step, terminating the reinvestments - or initially tapering them US-style - would surely be the gentlest way of tightening policy. In effect, tightening by 'doing nothing'.

“It would help keep rates low, and give the pound comfort the Bank was not falling 'behind the curve'. It may even go some way to reducing belatedly the downside of QE - still evidenced by asset-price distortions, suppressed saving, and funding strains still on many pension schemes.”

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