26 October 2015

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In March 2009 the Bank of England (BoE) lowered its base rate to a record-low 0.5% to combat the effects of the global financial crisis. Six-and-a-half years later, the BoE’s Monetary Policy Committee (MPC) voted at its October meeting to keep Bank Rate unchanged at 0.5%, despite the world – and notably the UK – having healed substantially from the crisis.

A base rate of 0.5% looks inconsistently low given the UK’s pace of growth and strong labour market. The economy expanded by 0.7% in the second quarter compared with the quarter before, according to Monetary Policy Committee minutes. Office for National Statistics (ONS) data show the unemployment rate fell to 5.4% for June to August 2015, having declined from 5.6% in the quarter to May. ONS figures also show employee earnings have grown strongly since mid-2014 and reached their highest level in over six years in the three months to July, rising by 2.9% year-on-year.

Inflation negative. Again.

Despite the robust economy and strong labour market, low inflation continues to concern policymakers. Such low inflation is primarily the result of oil prices having more than halved since last summer. Uncertainty over the near-term inflation path has increased although MPC members still expect a pickup around the turn of the year, according to the latest meeting minutes.

However, the UK has slipped into deflation for the second time this year as consumer price inflation (CPI) recorded -0.1% over the year to September after being flat in August. Clothing and motor fuel prices were the main downward contributors to inflation, which has now hovered at or around zero for most of 2015. When the UK last recorded deflation in April, it was for the first time on a CPI basis since official records began in 1996, and the first time since 1960 based on comparable historical estimates.

Has the market overreacted?

The 10-year gilt yield fell after the release of the latest inflation data as investors pushed back their expectations of when the BoE would first raise interest rates. The futures market isn’t now pricing a first rate rise until around a year’s time, according to Bloomberg data. We’re not convinced by this market reaction. While the BoE is expected to move sometime after the US Federal Reserve (Fed), the Fed is looking to start raising rates this year, or early in 2016, and we believe that this means UK rates could start rising long before the market expects.

CARS ref: RSM-2244
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 22 October 2015 and may change as subsequent conditions vary.

The Fed is looking to start raising rates this year, or early in 2016, and we believe that this means UK rates could start rising long before the market expects.