BOE: Bank on track

Today’s BOE decision represents a correction in UK policy makers’ thinking. The sudden stop in activity which was implied by the Bank’s August stimulus package has not materialised and the focus has instead returned to significantly above-target inflation by 2018. This is going to be supportive of sterling, especially as consensus views on the exchange rate had become so negative.

In the same week as the uncertainty over BOE Governor Mark Carney’s tenure was extinguished, the Bank of England’s Monetary Policy Committee has significantly changed its assessment of UK growth prospects and the likely trajectory of UK interest rates.

The idea of a sudden stop has been largely abandoned in favour of anticipating a longer period of slower growth over the 2016-2018 period, Exhibit 1. In addition, the guidance for a cut in interest rates this year has been dropped and the focus has shifted towards above-target inflation, Exhibit 2.

Exhibit 1: BOE November GDP forecasts – no longer expecting sudden stop in 2017

Exhibit 2: BOE Inflation forecasts significantly higher than August

We believe investors would be well advised to avoid linking these policy changes to the intense speculation over Mark Carney’s recent decision to remain in post until 2019. Instead, investors should credit the BOE for its willingness to change its position following better than expected incoming economic data. There was always a risk that the mini-stimulus package of a rate cut, guidance for a further rate cut in Q4 and asset purchases would be seen as an over-reaction in hindsight rather than a smart pre-emptive easing.

However, despite the rebound in economic data this quarter, including better than expected survey data and GDP numbers, investors should not drop their guard on Brexit in our view. The BOE may now be back on track but as the focus shifts to the impact on UK inflation from the depreciation in sterling, expectations for real rates should move higher. Furthermore, the elevated level of uncertainty in respect of the UK’s trading and political relationship with other nations will persist for a number of years.

The most recent example of this uncertainty was last week’s court decision requiring parliamentary approval of any Article 50 notification. In our view, this does not meaningfully change the probability that Article 50 will be triggered but adds significantly to the uncertainty over the timing. Most obviously, if this court decision is upheld on appeal, a UK general election may be required before Article 50 is triggered.

Quick Conclusions

1. Investors should be reassured by the Bank’s willingness to change course. The absence of a sudden stop in the UK has lowered the need for ’emergency’ monetary policies. This flexibility to respond to incoming data gives comfort that the stance of monetary policy is being adjusted to the prevailing conditions.

2. The modest bounce in sterling is should be a welcome development for the BOE and UK government. Sterling is now in a sweet spot which makes UK exports significantly more competitive but does not raise questions in terms of the UK’s financial stability.

3. It may not be an explicit policy objective but stability in the exchange rate and wider financial system is a necessary (although not sufficient) condition for a successful Brexit. In this respect, the BOE’s revised views on the direction of UK interest rates will be supportive of sterling – and the affirmation that Mark Carney will remain in post until 2019 is one less uncertainty for investors.