For the first time in over 10 years the Bank of England raised its official policy rate, a hike of 0.25% to 0.5%. The rationale is a combination of growth continuing at or slightly above trend, unemployment falling further from its current 42-year low, and the Monetary Policy Committee’s (MPC) expectation that inflation will remain above the 2% target for the next three years. While respecting the uncertainty surrounding Brexit, the MPC’s collective view is that the time has come to move away from the cyclical low on interest rates.
A slow and gradual rate cycle?
Inevitably there are questions that follow the first rate hike – is this a solitary move, or is this the start of an interest rate cycle?
The MPC will not want this to be seen as a solitary rise, but at the same time will not want to unsettle markets by guiding expectations towards a quick succession of hikes. Quite sensibly the MPC has gone out of its way to damp speculation of the latter by dropping the language about the market being too sanguine about the path of future rates.
The MPC has also acknowledged that its central expectation is for some kind of deal surrounding Brexit. We agree that a deal is the most likely outcome, and based on this we believe that market expectations for a cumulative 0.5% of additional interest rate rises by mid-2020 looks low. Rather we think the MPC would like to follow a path similar to that of the Federal Reserve, which has raised rates by a cumulative 0.75% since its initial hike in December 2015. The MPC will have certainly noted that to date the U.S. economy has continued smoothly through that slow and gradual rate cycle.
Implications for markets
In summary the MPC is wise to talk dovishly as it embarks on the beginning of a slow and gradual rate cycle – but slow and gradual can still mean more than 0.5% over three years. This suggests that UK gilts remain relatively rich, with better value available in overseas government bond markets such as the U.S. Assuming a smooth Brexit, we also see some scope for a stronger pound.