OpinionAug 28 2014

Oracle: Taking up the slack

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August marked the 66th month of the Bank of England holding interest rates at a record low, but this streak may soon come to an end. The questions many investors, market watchers and mortgage holders are asking themselves are: when will rates rise and what does ‘slack’ have to do with it?

Anyone expecting the BoE’s August Inflation Report to pave the way for a November rate rise would have been disappointed. Instead, in that report the BoE highlighted that very weak wage growth was a reason to believe the amount of slack in the economy may be greater than first thought.

The more dovish tone of BoE governor Mark Carney in the press conference saw markets, as measured by the forward rate curve, adjust their expectations of a rate hike into the early part of next year.

On the very technical measure of ‘economic slack’, the BoE reduced its estimate of 1-1.5 per cent of GDP to around 1 per cent of GDP. The concept of economic slack may seem foreign, but is simple enough — it is merely the amount of unused capacity in the economy.

When I get my morning brew and there is only one barista making flat whites with a little fern on top, when two baristas could operate the coffee machine, then that coffee machine is not being used to its full capacity and there is ‘coffee slack’.

The level of slack or spare capacity in the economy is of concern to the BoE, because it means there is unlikely to be any strong upward pressure on prices that would warrant higher interest rates. Remember that the BoE follows an inflation-targeting monetary policy, and adjusts the official policy rate with the aim of generating 2 per cent inflation over the medium term (say two to three years).

The projections in the August Inflation report are that inflation is likely to be below target over the next two years, suggesting the BoE does not see strong inflationary pressures either.

Inflation has fallen sharply since its peak of 5.1 per cent in September 2011. The combination of a stronger pound, which has pushed down the cost of imports, low wage growth and falling energy prices, has meant inflationary pressures have eased considerably.

For now, there appears to be little upside impetus for inflation, with wages barely moving and sterling likely to stay relatively strong given the anticipation of a coming BoE rate hike. In July, prices increased by 1.6 per cent year on year, below consensus forecasts, and this is another reason for the BoE to reconsider any near-term interest rate hike.

However, it may not be that clear cut. There is little doubt that the pace of improvement in the UK economy and the sharp decline in the unemployment rate has caught nearly everyone off guard, including the BoE, and this has led to ‘slack’ being eroded faster.

The trouble with the concept of slack is that it is difficult to actually measure, and governor Carney has noted that there was a wide range of views among the policy-setting committee about how much slack really exists. The BoE thinks most of the economic slack is concentrated in the labour market, and that unused capacity takes the form of workers who want to work more hours but are unable to and points to very weak wage growth as one indication of the degree of slack that does exist.

In the three months to June, wages actually fell by 0.2 per cent compared with a year ago. The numbers were distorted by the timing of bonus payments last year to beat the introduction of a higher tax band, but even when stripping out bonuses, wages were still only a paltry 0.6 per cent higher.

Meanwhile, the BoE has said that it does not have a threshold for wage growth that would trigger a rate hike. However, it is difficult to imagine that it is not being closely watched. But more important than current wage growth is future wages, and the “prospective path of wages...” the BoE puts it.

This may mean that wages only need to move in the right direction to warrant higher interest rates if it means the all-important slack is starting to disappear.

Wages only need to move in the right direction to warrant higher interest rates

Markets may have shifted and no longer be pricing in a rate hike this year, but I think the decision is still very finely balanced.

Kerry Craig is global market strategist for JP Morgan Asset Management