AXA IM's David Page - UK reaction: BoE defers negative rates even as growth outlook weakens

• The BoE left policy unchanged with Bank Rate at 0.1%, a gilt QE target of £875bn and corporate bond target of £20bn.
• The Bank requested institutions begin preparations for negative interest rates, but stressed it wanted to send no signal that they would ever be used at this point.
• The Monetary Policy Report described an uncertain outlook with the outlook boosted by vaccinations. However, the BoE reduced its 2021 growth outlook to 5% (7¼%) as we had expected.
• The BoE retained a more pessimistic outlook for supply, considering the UK likely to use up spare capacity by the end of this year.
• This supported its inflation outlook at target from around the middle of this year.
• We forecast inflation marginally softer, in part expecting further sterling gains.
• Despite not seeing an increase in QE at this meeting, we still expect a further £75bn, reverting to our previous view of a boost in May. We see Bank Rate unchanged in 2021 and 2022.
• Financial markets sharply repriced the probability of negative rates, driving rates and sterling higher.   

The Bank of England’s (BoE) Monetary Policy Committee left policy unchanged today at its meeting that included the publication of the Monetary Policy Report. This saw Bank rate left at 0.1%, the corporate bond asset purchase target at £20bn and the gilt target at $875bn. The decisions were unanimously made with the accompanying minutes recording that all members saw the current monetary policy stance as appropriate. The decisions were in line with market expectations, although we had considered the BoE likely to boost QE at this meeting, bringing forward our previous expectation for this boost to be in May.

Minutes and the Monetary Policy Report discussed the impact of the virus and additional restrictions on the economy versus the improved outlook that the vaccination roll out provided. The minutes described the outlook a remaining “unusually uncertain” with risks tilted to the downside, although less so than in November. However, the unexpected increase in the virus and reimposition of restrictions in the UK had “materially” altered the BoE’s expected path of GDP. Q4 GDP was now expected to come in at 0.6% - better than the -2.5% considered in November. However, the BoE now expected Q1 2021 to contract by 4%. This led to a sharp drop in the BoE’s expected growth for 2020 as a whole, which was reduced to 5% from 7¼% in 2021, while 2022 was revised higher to 7¼% from 6¼% in 2022. This is much more in line with our outlook (4.3% and 7.5%) and barring trivial differences in outlook over coming quarters (we forecast 0.4% and -3.5% for Q4 and Q1 respectively) the Exhibit below shows the BoE now has a very similar view of economic growth to our current expectations.   

Indeed, we consider many things similar to the BoE, including the BoE’s expectation that unemployment will peak at 7¾% around mid-year (our own estimate has been 7.6%). However, one key area of difference appears to be in regards to the economy’s supply capacity. While we have allowed for a modest drop in supply capacity that would see the economy with a positive output gap until 2023, the BoE considers conditions of excess demand to be reached by the end of this year. This impacts the outlook for inflation. The BoE expects inflation to rise sharply towards 2% by mid-year as base effects roll off – we concur. However, it expects inflation to hover around 2% for 2022 and 2023, where we consider inflation likely to average 1.5% next year – in part as we expect spare capacity to weigh on activity. We fully acknowledge that the outlook around the supply-side of the economy is uncertain and the BoE refers to two-sided risks to its own assessment, allowing for greater labour market scarring or transitional effects on the one hand, or an overestimation of the rise of the medium-term unemployment equilibrium on the other. This is likely to be a key factor in determining the ultimate inflation impact and hence policy outlook.

The BoE also presented the findings of the Prudential Regulation Authority’s (PRA) survey of financial institutions on the operational readiness of negative interest rates. The survey concluded that the adoption of negative rates within six month “would attract increased operational risks” with the Prudential Regulation Committee (PRC) concluding that this could “adversely impact some firms’ safety and soundness”. The MPC thus decided to “request that the PRA should engage with PRA-regulated firms to commence preparations in order to be ready to implement a negative Bank Rate at any point after six months”. However, the Bank was at pains to stress that this should in no way be interpreted a “signal that the setting of a negative Bank Rate … [was] imminent, or indeed in prospect at any time”. We have long held that the BoE would not reduce Bank Rate and would certainly not take Bank Rate negative. These findings strengthen our conviction: with our expectation that the UK will be undergoing a robust rebound in activity in six months, we do not expect the BoE to adopt an experimental monetary approach at this time. Further policy accommodation – if needed - at this time would most likely be provided with more persistent asset purchases or a signal of delayed tightening, rather than additional outright loosening. However, these preparations clearly expand the BoE’s toolkit for the future and leave the debate around negative rates live for the next material downturn.   

With this in mind, we continue to expect the BoE to fine-tune its monetary policy further in the coming months. The BoE’s current QE programme, which it intends to continue until the end of this year, implies quite a sharp slowing in the pace of asset purchases over the coming months. This would be a tapering in asset purchases much sooner than expected in the US or Eurozone. Mindful of Fed Chair Powell and RBA Governor Lowe’s recent comments warning about removing support too soon, we doubt that the BoE will want to break ranks with other international central banks for fear of a reaction in sterling. Although the BoE maintains that the current policy stance will see inflation at 2% over the policy-relevant time horizon, our own outlook is softer, which would be exacerbated if sterling rises further, both as markets price less chance of further interest rate cuts and continue a longer-term re-pricing as Brexit concerns and disruptions fade. As such, we still expect a modest increase to the QE total. We revert to our previous call of this being in May with an additional £75bn – a size consistent with the BoE continuing purchases at the current pace for most of this year and continuing at a slower pace into the first few months of 2022. Even then, this would see the BoE finish asset purchases ahead of our expectations for either the Fed or ECB.

Financial markets reacted sharply to the BoE’s views on negative interest rates (and marginally on disappointment of no further easing). 2-year and 10-year gilt yields rose sharply by 6bps and 7bps respectively as market expectations for negative rates were reduced – markets have consistently seen this as a prospect – rising to -0.04% and 0.43% respectively. This had an immediate impact on sterling, which rose by 0.8% to the US dollar to $1.368 and 0.9% to the euro which recorded £0.876 – its lowest rate since early November.