BOE governor’s rate hike signals something rotten in UK economy

Bloomberg

Bank of England (BOE) Governor Mark Carney is ready to raise interest rates from a position of economic weakness rather than strength.
The fastest inflation in four years has left the UK central bank preparing to hike next month for the first time in more than a decade, yet it’s not an accelerating economy fanning those price pressures. Instead, policy makers are being pushed to temper less benign inflationary forces generated by weak productivity and Brexit.
The UK has fallen to the bottom of the Group of Seven growth rankings, but also of concern is the fact that it’s far less productive than international peers. For Carney, who’s warned that leaving the European Union could worsen the situation, that means a lower rate of growth is already enough to put a strain on
resources, generating unwelcome
domestic pressures.
The International Monetary Fund (IMF) was the latest to sound the alert when it said the UK has been the “notable exception” this year among advanced economies. It left its forecast for 2017 expansion at 1.7 percent while raising estimates for the world, US and euro area.
It’s a far cry from Janet Yellen’s buildup to the first Federal Reserve hike in 2015. While she signaled confidence in the economy, Carney has spoken of Brexit-related uncertainties delaying investment, reducing vital labor supply and creating a lower “speed limit.”
The supply capacity of the UK will expand at “only modest rates in coming years,” he said last month. While the weaker pound has boosted headline inflation, lower potential growth creates a risk of more persistent pressures as remaining spare capacity is absorbed faster. The BOE already sees inflation staying above its 2 percent target for the next three years.
“It’s sort of the opposite of the U.S. story, where everyone’s saying ‘if we’re raising interest rates and getting on with QE unwinding it’s because it’s a sign of strength,”’ said Victoria Clarke, an economist at Investec in London. “In the U.K. it’s a very different background, and there seem to be some more complicated reasons — one of which is that they’re worried about a bit more of a persistent inflation problem.”
There’s a near 90 percent chance of a 25-basis-point increase on Nov. 2, according to market pricing, which would reverse the stimulus after the 2016 Brexit referendum. After rising in the wake of the BOE’s comments alongside its last decision in September, the pound has now fallen back to about the same level as before the meeting. It was trading at $1.3203 as of 9:34 a.m. in London.
Analysis by Bloomberg Intelligence shows that since 1997, the BOE has only raised rates when quarterly growth has been at least 0.5 percent. While expansion this year has only been 0.3 percent, for the BOE, reduced potential means that’s enough to erode spare capacity.
The BOE doesn’t publish a figure for potential economic growth, though policy maker Michael Saunders estimates it’s about 1.5 percent, below the pre-crisis average of
2.5 percent.
While weak productivity growth isn’t a U.K.-only problem, the disappointing performance — up less than 1 percent in a decade — has left output per hour 15 percent below the G-7 average. The UK Treasury said that it’s a “longstanding challenge,” after a gloomy report from its fiscal watchdog.
While the BOE had been looking for a wage-growth pickup before tightening, the lowest jobless rate in four decades and the reduced supply capacity prompted it to “call time on that strategy,” according to BI economists Dan Hanson and Jamie Murray.