A bumpy ride for the BoE

Declining wages and a falling unemployment rate highlight the uneven nature of UK economic growth, which is likely to see the BoE take a conservative approach to raising rates.

Is the United Kingdom ready for a cash rate rise? Minutes from the Bank of England’s July meeting suggest that there was some disagreement on when the bank should begin to raise rates from historically low levels.

In the end the bank opted to leave rates at 0.5 per cent and maintain its stock of asset purchases at £375 billion. Neither decision came as a shock but bank officials have hinted in recent weeks that a rate rise could occur earlier than the market anticipates. The minutes did little to contradict those comments.

Clearly some members of the committee are feeling a little less comfortable with such low lending rates, particularly with the labour market firming and the recovery gaining momentum, and are keen to shift policy gradually towards a more neutral setting.

The UK economy rose by 0.8 per cent in the March quarter, outpacing Europe and most of the developed world, and is set to rise at a solid pace throughout the remainder of the year. According to the Institute of Economic and Social Research, the UK economy expanded by around 0.9 per cent during the second quarter.

But while a rate rise by the end of the year seems inevitable, it isn’t all smooth sailing. Some recent data highlights the uneven (and some might say confusing) nature of UK growth.

Inflation rose unexpected in June to be 1.9 per cent higher over the year. The core measure, which excludes volatile items such as food and energy, picked up to 2.0 per cent over the year to June. Both measures are below the BoE’s upper target for annual inflation of 2 per cent.

Although the labour market has improved, with employment rising and the unemployment rate falling rapidly, the same cannot be said of wage growth. Real wages continue to decline, with annual growth falling for the past five years.

The Committee offered two possible explanations for the contrast between wage and employment growth. First, lags between the labour market tightening and wages rising were longer than the Committee had previous judged. Second, the effective supply of labour had increased, resulting in a greater degree of slack than was previously expected.

Neither explanation will ease the concern of households who continue to see their purchasing power decline.

Labour productivity remains a problem for the UK economy, with gains in employment not providing the bang-for-its-buck that you might expect. If productivity improves -- as the BoE expects -- then inflationary pressures will recede until wages begin to pick up.

The British pound also continues to be strong, hovering around a six-year high against the US dollar. This is set to weigh on export growth and inflation, reducing the urgency for a rate rise.

The BoE has also taken steps to reduce their urgency by introducing measures to slow household lending. Under new guidelines, mortgage lenders will be required to ensure that no more than 15 per cent of their new home loans have a loan-to-income ratio of more than 4.5 times. These measures are designed to cool an increasingly dangerous housing market.

Financial markets continue to price in a rate rise to around 2.5 per cent over the next three years, well below the pre-crisis average of around 5 per cent. Those expectations appear reasonable at this point in time, consistent with the BoE taking a conservative approach to raising rates.

The UK economy is set to go from strength-to-strength over the second half of 2014 and is well placed for next year as well. But clearly there are some complicating factors that will encourage the BoE to take a cautious approach to monetary tightening. Nevertheless, economic conditions suggest that the BoE will begin their tightening phase by the end of the year or, at the latest, early next year.