In line with our expectation, the Bank of England (BoE) made no policy changes at its May meeting and reiterated its neutral stance by repeating it could move ‘in either direction‘.
However, against our expectation, the BoE also maintained its hawkish twist. First, Kristin Forbes (a known hawk) still voted for a hike (note, though, that she is leaving the BoE on 30 June 2017, which makes her hawkish stance less important). Second, some members still think that ‘…it would take relatively little further upside news…for them to consider that a more immediate reduction in policy support might be warranted’. The meeting summary also states that the BoE thinks the current market pricing of BoE hikes is a bit too soft if the economy lives up to the expectations. Still, markets had expected an even more hawkish Bank of England.
We still expect the BoE to remain on hold for the next 12 months. While we think it is unlikely the BoE will tighten monetary policy in a time of elevated political uncertainty, we think we would need to see substantially slower growth and/or higher unemployment before easing becomes likely again.
Note that the BoE reaction function has changed since the financial crisis: the BoE puts more weight on growth/unemployment relative to inflation (see also a speech by former Monetary Policy Committee member Martin Weale here, 18 July 2016). In our view, the BoE seems to be more worried about slower growth than too-high inflation if this is only temporary.
EUR/GBP remains trapped in the 0.84-0.85 range ahead of the UK election
Despite some hawkish comments on the BoE view on rate hike prospects relative to the market’s pricing, EUR/GBP traded higher following the BoE announcement.
As such, there are probably three reasons the EUR/GBP has bounced today.
- We think many investors expected a tighter voting split, with one or more members joining Forbes’ vote in favour of a rate increase.
- 2. The BoE revised its CPI inflation projection lower, which does not support the case for a rate hike any time soon.
- The BoE’s fairly optimistic outlook for growth is conditioned on the assumption of a smooth Brexit, which remains highly uncertain.
We still expect EUR/GBP to remain trapped in the 0.84-0.85 range ahead of the general election on 8 June.
We target 0.84 in 1M and would still look to sell EUR/GBP (preferably via options) if spot goes up to 0.8550.
Longer term, the outlook for EUR/GBP depends largely on the outcome of the general election.
Too hawkish BoE pricing, in our view
BoE has lowered its CPI inflation projections
The BoE has lowered its CPI inflation projections due mainly to the appreciation of GBP since the latest inflation report in February.
The BoE still expects CPI inflation to move higher, as ‘the ef fects of the fall in sterling and rising foreign export prices continue to feed through’.
The BoE says that ‘the projected overshoot entirely ref lects’ the GBP depreciation since November 2015 and that ‘although domestically generated inflation had been rising, it was currently below the level broadly consistent with the inf lation target’.
This supports our view that the BoE will see through higher inflation if it is only temporary due to currency changes. In our view, a trigger for a more hawkish BoE would be higher domestically generated inflation.
BoE expects GDP growth of around 1.75% in coming years
The UK grew 0.3% q/q in Q1, lower than the BoE expected back in February. Note though that the BoE expects this to be revised up.
The BoE expects the economy to grow around 0.4% q/q in coming quarters.
The BoE expects a smooth Brexit.
The BoE expects private consumption growth to recover ‘in the latter part of the forecast period as real income picks up‘, so higher nominal wage growth is an important underlying assumption.
BoE expects unemployment to stabilise at 4.7%
The BoE has lowered its projection for the unemployment rate, as it has lifted its projection for GDP growth.
The BoE now expects the unemployment rate to stabilise around the current level of 4.7%, slightly above the NAIRU estimate of 4.5%, implying there is still slack left in the labour market.
