As we expected, the Bank of England (BoE) did not change its monetary policy at its meeting on 11 May. The Bank Rate was held at 0.25% and the stock of UK government bond purchases was maintained at GBP 435 billion and that of corporate bond purchases at GBP 10 billion.
In its inflation report, where the Bank’s forecasts are published, the BoE was slightly more confident about the outlook for economic activity and prices: it revised up its growth forecasts for 2018 and 2019 and revised down its inflation forecasts for the same two years. It also indicated that if Brexit turns out to be a smooth process, it could tighten monetary policy earlier than the end of 2019, the timeframe currently expected by the markets.
Given that sterling has recorded a 2.5% rise in its trade-weighted exchange rate since the snap general election was called in April, the slight downward revision in the inflation forecast was not unexpected. But the upward revision to the growth forecast came as more of a surprise.
The latest data from the UK showed a major slowdown in economic activity. GDP grew by only 0.3% in the first quarter, down from 0.7% in the final quarter of 2016. This deceleration was mainly due to a contraction in the services sector. Retail trade and accommodation services fared particularly poorly (-0.5% in Q1 after 2.0% in Q4 2016), pointing to more lacklustre consumer spending.
Real retail sales were down 1.8% in March, and new car registrations fell 20% year on year in April – more signs that consumer spending, which accounts for 66% of GDP, has slowed.
This weakening in consumer spending, which is in keeping with our scenario, is a result of households' lower purchasing power following the uptick in inflation. In February, real income – i.e. excluding inflation – was down 0.1%.
In its inflation report, the BoE duly noted this trend and pointed out that the slower property market and tighter consumer credit conditions were also weighing on consumer spending. But the BoE believes that weaker consumer spending – a trend that looks set to continue over the coming quarters – should be more than offset by an uptick in business investment.
The BoE thinks that firm global demand and sterling's recent decline will encourage UK exporters to invest more. It therefore revised up its investment growth forecast from -0.25% to 1.75% for 2017 and from 2.00% to 3.25% for 2018. It expects investment to grow by 3.00% in 2019.
So the BoE, which acknowledged in its meeting minutes that its greatest challenge lies in "assessing the economic implications of the United Kingdom withdrawing from the European Union", expects investment to rise sharply in 2017 and 2018 – at a time when the terms of the UK's withdrawal will not yet be known.
Analysis and implications:
- Once again, the BoE wants to provide reassurance by releasing optimistic UK growth and inflation forecasts.
- We do not share the BoE's view that UK business investment will pick up. In fact, we think the slowdown in consumer spending and the uncertainty surrounding the terms of the UK's withdrawal from the EU will continue to weigh on investment decisions.
- We continue to expect UK economic growth to slow considerably in 2017 and 2018, while inflation should keep rising.
- Our forecast is still that, in light of stagflation, the BoE will not change its monetary policy in 2017 and 2018.
- Investors' disappointment in economic activity should push down the pound in the coming months. We still expect the pound to drop to USD 1.20 by the end of 2017.