The Bank of England’s (BoE’s) first rate rise in a decade was widely expected by markets, with Governor Mark Carney’s suggestion that even in a relatively optimistic scenario for the economy, only two more rate rises would probably be required over the next three years leading to a fall in the pound and in gilt yields.
Mr Carney said that the economy was operating with limited spare capacity and that low unemployment was expected to start translating into higher wage growth. Wage growth has so far failed to accelerate meaningfully, but job vacancies are at elevated levels and surveys suggest wage growth will start to accelerate.
Mr Carney also observed that wage growth has risen for new recruits. The inflation report notes that the BoE estimate that recent growth in employment has been disproportionate among occupations typically associated with lower wages, pushing down on measures of average wage growth. In addition, continued low productivity growth should mean that the economy has limited potential to grow and not generate inflationary pressures as demand bumps up against diminishing spare capacity.
Coping with a rate rise
Carney said that households are well positioned to withstand a rate rise. The average outstanding mortgage is about £125,000 and the BoE estimates that this rate rise would lead to an increase of around £15 a month on that average mortgage, if fully passed through.
About one-fifth of those who have a mortgage have never experienced a rise in interest rates since they took on a mortgage. The Inflation Report also notes that only about one-third of households have mortgages and less than 1.5 per cent of households spend more than 40 per cent of their pre-tax income on their mortgage.
Another important factor to note is that 60 per cent of outstanding mortgages are now on fixed rates - up from only about 30 per cent in 2012. Just under half of those fixed-rate mortgages are fixed for more than two years. This means that there will be some delay in the pass-through of higher borrowing costs. Companies are currently enjoying debt servicing costs near record lows and this rate rise still leaves them very low by historical standards. So, while this increase in interest rates will be a drag on the economy, its impact should be relatively small and manageable.
Mr Carney noted that the BoE would remain flexible in adjusting to economic developments and in particular to the outcome of the ongoing Brexit negotiations. He noted that based on the BoE’s current assumptions for the economy, maintaining interest rates at their current level woul d not be sufficient to bring inflation back close enough to target within an already extended time horizon of the next three years.
However, he said that only two more rate rises over the next three years would probably be enough to bring inflation back to target, in line with their guidance that any future rate rises would be at a “gradual pace and to a limited extent”.
The BoE is keen to signal that rates are unlikely to rise very quickly at all. However, without knowing whether the UK will secure a transitional Brexit deal or the final outcome of trade negotiations with the European Union, the Monetary Policy Committee (MPC) is essentially being forced to drive blindfolded when it comes to setting monetary policy.
Concerns that the outlook for the UK economy may be less positive than the BoE’s assumption would now justify an expectation of less than two rate rises in the next three years. We see potential downside risks to the economy and to the outcome of the Brexit negotiations. As such, we think being overweight stocks that get most of their revenues from within the UK, such as many mid- and small-cap stocks, is a potential risk.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
