Why the Bank of England May Move Before the Fed
The latest rounds of data in the U.S. and the U.K. are pointing to a conclusion that few thought likely a few months ago: The appropriate time for the first post-crisis rate rise by the Bank of England may be reached before the Federal Open Market Committee votes to move.
Both central banks have been waiting for clear signs that their respective economies are moving back toward potential, with the greatest number of people in work and much of the output lost following the financial crisis recaptured. Yet while the Federal Reserve can still point to low prime-age labor force participation, a quits rate that has remained static for five straight months, and weak wage pressures to justify its inaction, the Bank of England is increasingly reliant on its optimistic productivity forecasts to make a case for holding.
Although headline inflation in the U.K. fell 0.1 percent in September, it is likely to start picking up toward the end of the year as the effects from falls in commodity prices and university tuition fee increases drop out. Below is a chart complied by Bloomberg Intelligence showing the anticipated impact of these base effects on inflation:
Dan Hanson, an economist with Bloomberg Intelligence, said that in the absence of further sharp downward movements in global commodity prices, "inflation is likely to accelerate quickly beyond October."
In the U.S., this could be mitigated by an increase in the number of people coming back into the job market. With Britain's jobless rate, however, hovering just above the bank's estimate of the natural rate of unemployment, employment as a share of the working-age population at a record high, and wages and output continuing to rise at a robust pace, the bank is relying on productivity growth to offset price pressures.
Productivity flat-lined in 2014 but has since started to exceed expectations, rising 0.8 percent in the four quarters through March 2015 and is expected to have been 1.5 percent in the year ended June. With nominal wage growth projected to be 3 percent to 4 percent out to 2016, productivity growth would have to average around 1-2 percent for the Bank to hit its 2 percent inflation target.
This would be below its precrisis average rate of 2.4 percent but substantially above the negligible productivity growth seen since 2008.
Unfortunately, the record of both the bank and the Office for Budget Responsibility, the government's budget watchdog, at forecasting productivity since 2008 has done little to inspire confidence in the current projections. The OBR's forecast below shows the extent of the revisions to the outlook:
Importantly, the charts illustrate that there have been forecasting errors in both directions, suggesting that the current outlook could just as easily prove too pessimistic as optimistic. Still, given the time it has taken for U.K. productivity to start recovering, the available slack is likely to be lower than the earliest estimates suggested.
Another key uncertainty, highlighted by Monetary Policy Committee member Kristin Forbes in a speech last month, is the impact of foreign exchange movements on prices.
Tony Yates, a former BOE official and professor of economics at Birmingham University, said the bank has been surprised by the relatively weak pass-through of a stronger pound on domestic prices.
"The big thing they'll be looking at is the pass-through of foreign exchange movements on tradeable goods prices after the unusually weak pass-through from the recent strengthening of sterling," Yates said. "The bank's model would say that it should already have washed out by now, but it seems to be taking much longer than expected."
All else being equal, an appreciation in the trade-weighted value of a currency should reduce inflation, with the bank estimating that the 17 percent appreciation of sterling since the spring of 2013 should have lowered consumer price inflation by between 3 percent and 5 percent. The outcome, however, has been far shallower than theory suggested.
Without a more complete understanding of what Forbes calls the "crucial relationship" between exchange rate movements and inflation, it will remain difficult for the MPC to accurately gauge the speed of the pickup in prices and set market expectations for the path of rates.
Bloomberg's Hanson said that assumptions about the effect of exchange rate moves are becoming much more important for the pace at which inflation moves back to target.
Unlike in the U.S., there are fewer clear indicators that the U.K. economy is operating significantly below potential, so the margin for error is narrowing. It is no longer outlandish to argue that the bank should move before the Fed.