The Bank of England joins the “hikers”

Following in the footsteps of the United States Federal Reserve and the Bank of Canada, the Bank of England now looks set to join the “hikers.” A couple of increases in interest rates this year, at least, may kick off in the spring. What's the thinking here? The key issue is the economy's supply side.

The Bank has revised up its expectation of GDP growth this year by 0.1 per cent to 1.8 per cent, and is comforted by the buoyancy of the global economy. But it is disappointing that UK economic growth isn’t matching the upward adjustments to growth in the US, the European Union and emerging markets. As the bulk of independent forecasters have noted for some time, this can be attributed to the related combination of a weak investment cycle, persistent Brexit uncertainty, and higher inflation. Inflation looks likely to continue to exceed the Bank’s 2 per cent target over the next three years.

The Bank can’t do anything about investment and Brexit, but inflation most certainly lies within its remit. Although it thinks the post-Brexit fall in sterling, as a cause of higher prices, is pretty much over now it is not happy that inflation will remain above target. While it was previously prepared to tolerate higher inflation to support employment growth and economic activity, it now judges that both have reached the point where the trade-off with interest rate inactivity is no longer justified. The Bank’s Governor, Mark Carney, confirmed after the release of the quarterly Inflation Report last week that increases in interest rates were likely earlier and faster than previously expected.

Putting all this another way, the good news is that the economy looks reasonably stable now, notwithstanding Brexit, and has achieved the lowest level of unemployment for 42 years. The Bank thinks that the growth in wages and salaries is now starting to rise slowly, and will reach around 3 per cent. As it does so, the previously negative gap with regard to inflation will close, and pay could edge above inflation.

The bad news is that the Bank thinks there is very little slack in the economy, perhaps no more than 0.25 per cent of GDP. The Bank’s economists think that while there may be more slack in the labour market—more workers could do more hours of full time work, for example—there is less in the company sector where capacity utilisation is tight. This in turn could mean that companies will be more likely to raise prices.

Low slack means that the economy can only continue to expand at a rate we all find acceptable without higher inflation if the supply side of the economy expands too. Because Britain’s ageing society means a slowdown or fall in the supply of labour—made worse as the country tries to limit immigration—we cannot look to milk more than about 0.4 per cent per year of growth for the next three years from the labour supply according to the Bank. This is about a third of what it was a decade ago.

The only alternative is higher productivity growth, but the Bank sees no change in underlying conditions that could lift the economy’s trend growth rate. Leaving aside issues of measurement, the productivity funk could be down to many factors including the ageing workforce, the stall in educational attainment levels, a tighter post-financial crisis regulatory environment, and a shift in occupational structure towards lower productivity jobs. The Bank is surely right in anticipating that none of these is going to change much for the time being.

Moreover, if we don’t have vibrant investment, there is little chance of reaping a better productivity harvest. The Bank noted rising investment, but also that it has been historically weak, especially given global demand has been strong and also supportive financial conditions at home. Using comprehensive survey evidence, the Bank’s information is that weakness can be attributed in large measure to Brexit-related uncertainty.

Strictly speaking, the impact of Brexit should be mixed. Businesses heavily reliant on exports will most likely be hit, while others that use Brexit as an opportunity to substitute domestic for imported goods will benefit. The pattern of Brexit will help determine the balance. Yet, none of them can really make investment plans if they don’t know what the UK’s trade relationships with the EU and non-EU countries are going to look like.

It follows that greater clarity about what the government wants, and might get, in the Brexit negotiations will have a significant impact on the investment climate, one way or another. But such clarity is sorely missing, and many companies are fretting about the confusion and lack of realism.

Referring to the possibility that there may be no satisfactory trade deal with the EU, Japan’s ambassador to the UK, Koji Tsuruoka, spoke for his country’s many well-known companies with a UK presence last week. After leading a delegation of major Japanese names at a meeting with Theresa May, he said: “If there is no profitability of continuing operations in the UK—not Japanese only—then no private company can continue operations. It is as simple as that.”

If investment took a big dive as a result of failure to reach a satisfactory Brexit trade agreement with the EU, the UK economy’s supply side would be hit with still greater ferocity. We must hope that the Bank’s current Brexit scenarios play out as uneventfully as assumed in its current outlook. Businesses though need more than hope to invest.