David Absolon, Investment Director at Heartwood Investment Management, on the validity of the Bank of England’s assumptions in its latest Quarterly Inflation Report:
Notwithstanding its poor track record of forecasting inflation, how valid are the Bank of England’s (BoE) assumptions in its latest Quarterly Inflation Report?
The BoE will be reassured by two factors. First, there are nascent signs that wage growth is finally picking up: total pay and regular pay (ex bonuses) increased 1% and 1.3%, respectively, for the three-month period ended September, 2014. Note that the increase in regular pay was slightly higher than current inflation.
Second, and more importantly, real take home pay, cited by the BoE as one of the factors contributing to an above-trend growth outlook over the next three years, is likely to rise because inflation is low.
Politics may have some impact on wage growth as we head into an election year in 2015. Already we are seeing reports that some employers are providing one-off adjustments, well above current inflation, to make amends for using zero-hours contracts and low pay. Given the increasing focus on the “Living Wage”, private sector wage momentum may build, albeit in the relatively low paid/low skilled labour market sectors.
Moreover, the confluence of low inflation, lower commodity prices and low interest rates, set against a backdrop of an improving labour market, is supportive of consumption and, therefore, the longer-term growth and inflation outlook.
What does this mean for the UK gilt market? In the near term, we do not expect any significant movement – yields have moved a long way since the summer, both on an absolute basis and relative to the US Treasury market. It is noteworthy that the short-end of the UK market has now converged with the US.
Over the year, we have been consistent in our view that:
1) the front end of the UK gilt curve was pricing in too many rate hikes
2) the Federal Reserve would probably hike before the Bank of England because the US economy was built on stronger foundations. These views have been tested but the market has now moved in line with our expectations.
Given the natural softening in UK data trends of late, following strong growth in the first half of the year, we expect to see the first rate rise in 2015 in both the UK and US – a few months ago the UK market was pricing in a rate rise in November, 2014! The market is now priced for the Federal Reserve to raise rates before the BoE, which we believe is fair.