The Hindu Business Line : BoE's aggressive rate hike stance not warranted

THE Bank of England has earned the distinction of handling the global downward cycle fairly well and avoiding a technical recession during the last few years.

It cut the rates in response to the global events at the right time even though the domestic economy was not showing any visible signs of weakness. The central bank was also aware that the interest rates had been brought to all-time lows and that it had stoked the strong rally in the real estate sector. The household debt has burgeoned sharply and leaves it vulnerable to any interest rate up-move.

The Bank of England (BoE) has also proactively started the rate hike cycle to send the right signals and prevent the economy from overheating. Now that the rate hike cycle has started, the financial markets are factoring in the same and the yield curve has adjusted. Is an aggressive rate hike cycle possible? What is the market pricing in? We would look at these issues in this article.

The Monetary Policy Committee in its minutes even as far back as January 2000 had an opinion that an increase of 50 basis points was required as the strength in consumption due to global recovery would result in GDP to continue above trend rate. This would exert pressure on inflation in the medium term even though the short-term inflation is below the 2.5 per cent mark.

One of the concerns was lack of spare capacity which could drive the prices higher. Since that time the GDP has grown at above trend rate but inflation has gone above target rate only for two months. This would imply that the relationship between estimates of spare capacity and inflation are unclear. Obviously this is not to imply that capacity utilisation is not relevant but would indicate that there are other factors at play such as relative strength of currency and competitive pressures.

Both these factors have been crucial in offsetting the domestic inflation. The lack of spare capacity should show through higher service sector inflation. However, cost pressures remain benign and demand for consumer services has eased markedly.

There are different forces working in the goods and service sectors. There is low goods inflation due to weak cost-push pressure and upward demand-pull pressure in the service sector. These two have offset each other, keeping the inflation in check.

Sterling had been exceptionally strong against the dollar and had moved briefly above 1.90. The strength of sterling has also acted as a rate hike and stemmed the inflation. The BoE , sensing that if the strength continues unabated it would create a problem, tried to talk it down. Sterling corrected and moved down close to 1.75 against the dollar but has once again started the rally and closed the fortnight above 1.83.

The financial markets are moving to currencies that are leading the interest rate cycle and promise higher yields. Sterling is in the company of Australian dollar in this category.

Bank of England's tactics of getting the market to price in inflationary expectations has worked. Since January 2003, the five and the ten-year bond yield in the UK have risen by 88 and 81 basis points respectively. The entire move is on the back of inflationary expectations.

If one looks at the breakeven inflation rates as measured by the gap between index-linked bond and the nominal bond, it is averaging slightly above three per cent. The inflation-linked bond has a return that is linked to inflation and does not include the inflation-expectation premium that the normal bond prices in. The difference of these two would indicate this premium or the inflation expectation over this time horizon. The markets are suggesting that they expect the inflation to shoot above target of 2.5 per cent on a persistent basis going forward. This has not happened since 1997. The central bank would also need to keep in mind the vulnerability of the housing sector to the hike in interest rates and cause a dent on consumption. There could be a negative wealth effect if the real estate sector gets hurt. If one takes all the factors into account it is clear that the inflationary expectations may have been overdone. The inflation threat does not look imminent.

However, the interest rates and nominal bond yields would continue to rise a bit faster than what the market expects over the next one year.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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