Could the next move in interest rates be down rather than up?

One pound coin on fluctuating graph. Rate of the pound sterling

Disinflation and deflation have been spreading around the globe in recent months and the UK economy has not been immune from this trend either. Today Governor Mark Carney warned that the UK’s recent trend of reducing rates of inflation (i.e. disinflation) could turn to deflation, which is negative rates of inflation (falling prices), in the next few months. The annual rate of consumer price inflation (CPI) hit 0.5% in December – its joint-lowest rate since the series began in 1989. A new record low is expected next Tuesday when January’s inflation figures are released. Thereafter, the annual rate is more likely to go into negative territory which should trigger a series of headlines stating ‘the UK enters deflation’

However, such a move will not be quite as dramatic as the headlines are likely to suggest. Indeed, Governor Carney was quick to highlight at this morning’s press conference that a temporary period of food, petrol and energy price induced deflation was nothing to worry about. The Monetary Policy Committee (MPC) estimates that two-thirds of the gap between the current inflation rate (0.5%) and the target (2.0%) is explained by the sharp falls in food and energy. Governor Carney insistent that there was no threat of persistent deflation in the UK as was experienced in Japan.

In fact, falling energy and food prices coupled with rising wages are set to boost household finances and economic growth this year. As a result, real take home pay is set to increase in 2015 at its fastest rate in a decade. Back in November, the Bank of England forecast real post-tax household income to rise by just 1.25% this year. Fast forward three months and after-tax incomes are now expected to rise by 3.5%, which is well above the pre-downturn long-term average of 3%.

It should be noted that a barrel of Brent crude oil was north of $80 when the Bank of England produced their last set of forecasts in November. Today Brent crude is trading at around $56 per barrel, having touched a low of $46pb last month. Whilst households’ costs are falling, average weekly earnings are set to increase at an accelerating rate. UK average weekly earnings forecasts for 2015 (3.5% y/y) and 2016 (4.0% y/y) have been revised up relative to November. In turn, this favourable backdrop for consumer spending has contributed to a modest upgrade in the Bank of England’s economic growth projections too. UK GDP is expected to expand by 2.9% this year and by 2.6% in 2016.

Whilst the UK economic growth projections are encouraging, there will be some concern that it is the wrong type of economic growth. We frequently hear that the UK economy needs to re-balance away from consumer spending towards exports and business investment. However, the latest set of forecasts reveals that the opposite is in fact occurring. The anticipated growth rates for UK exports, business investment and housing investment have all been revised downwards for 2015 relative to November’s forecasts. Conversely, household consumption is expected to grow at 3.5% y/y this year, up from 2.5% relative to November’s forecast.

The strength of sterling, particularly vis-à-vis the euro, will adversely affect UK exporters. The pound has strengthened further on the back of today’s Quarterly Inflation Report. This is largely due to the fact that the latest CPI projections, assuming the financial markets’ expectations of interest rates, will hit the 2% target in two years’ time and rise above target within a three-year time horizon. This has led financial markets to bring forward their expectations for an interest rate rise from Q3 2016 a couple of weeks ago to Q1 2016. A first hike in February 2016 remains my base case.

Whilst everyone is trying to pinpoint when the next rate rise will come, Mark Carney introduced an interesting thought. Namely, the next move in Bank Rate could be down and not up if conditions warranted it. Since March 2009, Bank Rate has remained at its lowest rate (0.5%) since the Bank of England was established in 1694. It was assumed that 0.5% represented the interest rate floor. However, in recent weeks an increasing number of central banks have introduced negative interest rates with the Swedish Riksbank adopting such a rate today. In today’s press conference today, Governor Carney interestingly responded to a question by commenting that the Bank of England Bank Rate could be cut if necessary. Those on base rate tracker mortgages will have pricked up their ears for that one. Clearly the economic outlook and the latest projections are steeped in uncertainty.

So, when it comes to the record low Bank Rate, the phrase ‘the only way is up’ does not apply!

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