The Outlook: July 2019 
economic commentary


Concerns over slowing growth and below-target inflation are likely to see the US Federal Reserve and European Central Bank loosen monetary policy during the coming weeks. But the UK interest rate outlook remains highly dependent on Brexit.

Shifting expectations for the course of monetary policy has been a key driver of global financial markets this year. Against the backdrop of a slowing global economy and heightened uncertainty resulting from ongoing US-China trade war, central bankers in the US, Europe and Asia have dropped strong hints in recent weeks that looser monetary policy is on the way.

The dramatic turnaround in policy direction has been led by the US central bank, the Federal Reserve (or ‘Fed’). Not so long ago, the Fed was in hiking mode, raising rates by 25 basis points in December for the fourth time in 2018. However, signals from Fed officials have become increasingly dovish in recent months. In testimony before Congress on 11-12 July, Fed Chairman Jerome Powell, citing increased uncertainties about the economic outlook and muted inflation pressures, appeared to reinforce market expectations that rates would be cut at the end of July.

The more dovish tone has been echoed at the European Central Bank (ECB). In June, ECB governor Mario Draghi said the ECB was prepared to cut rates or restart its quantitative easing (QE or bond buying) programme if soft economic data continued. The recent nomination of Christine Lagarde – a supporter of negative interest rates and QE during her stint at the IMF - to replace Draghi as head of the ECB later this year has also fuelled expectations of further stimulus.

Downside growth risks

Several factors have prompted central bankers to turn more dovish. Firstly, growth has slowed. The US-China tariff war has taken its toll on global trade and business sentiment, which in turn has depressed investment and manufacturing activity. One indicator of global manufacturing, the JP Morgan manufacturing PMI index, has recently shown output in the sector contracting for the first time in three years. Although manufacturing makes up a smaller share of developed market economies than it used to, and the service sector has generally held up better recently, there is a risk that weakness will spread.

Moreover, geopolitics present further downside risks. The June G20 meeting between President Trump and President Xi Jinping saw both leaders agreeing to resume trade talks and not escalate tariffs, but given major disagreements between the two countries, the risk of a broadening of the conflict remains. Such a development could further depress business confidence and weigh on activity.

Below-target inflation

In addition, policymakers at both the ECB and the Fed are concerned that inflation is too low. Inflation on the Fed’s preferred measure – the so-called core PCE deflator – has consistently undershot the bank’s 2% target since the crisis and stood at 1.6% in May. Inflation in the eurozone – just 1.2% in June 2019 - has been even weaker, and the ECB’s own forecasts anticipate a continued undershot of its ‘below but close to 2%’ target. What’s more, market-based measures of inflation expectations in both regions suggest investors are starting to doubt central bankers’ ability to raise inflation towards their target over the longer term. 

The consistent undershoot of inflation is prompting policymakers to reassess what level of interest rates is appropriate for the economy. After a period of economic expansion, policymakers have traditionally started to raise interest rates as slack in the economy is eroded, unemployment falls and inflationary pressures start to build. However, on 11 July, Powell observed that the relationship between unemployment and inflation had “become weaker and weaker and weaker.”

There are several factors that might explain why the inverse relationship between unemployment and inflation – which economists call the “Phillips Curve” – is less strong than it used to be. Globalisation and technological developments have born down on the prices of traded goods.  Central bank credibility has caused workers and employers to expect future inflation to come in close to target, thereby anchoring wage demands. De-unionisation, automation and the deregulation of labour markets have meant workers have less bargaining power.

In practical terms, this suggests policymakers are warming to the idea that unemployment can fall further than they previously thought without triggering an acceleration in inflation. In turn, this would enable the Fed to set interest rates at lower levels than they would have previously anticipated. The Fed has also indicated that it is considering the adoption of so-called ‘makeup’ strategies under which it would allow inflation to rise above its 2% target to compensate for earlier periods of sub-2% inflation.

UK rate outlook dependent on Brexit

It should be noted that one country where investors still anticipate future inflation coming in above target is the UK. The 10-year breakeven inflation rate – the difference between the yield on a conventional 10-year government bond and an equivalent inflation-protected one – currently stands around 1.7% in the US, but in the UK is around 3.2%. Taking in to account technical factors (index-linked bonds are adjusted by RPI, while the Bank of England targets CPI), this suggests investors expect inflation, on average, to marginally exceed the Bank of England’s 2% inflation target over the next 10 years.

One interpretation of this is that, in light of the increased risk of a no-deal Brexit under a future Prime Minister Boris Johnson, markets are anticipating a further depreciation of the pound and a renewed jump in import prices.

However, it could also be a reflection of greater domestically-generated price pressures. In a speech on 2 July, Bank of England Governor Mark Carney sounded more dovish than he had earlier in the year, acknowledging downside risks to global and UK growth. But he also noted that “Unlike many other jurisdictions, inflation in the UK is currently at the MPC’s 2% target, the labour market remains tight with wages and unit labour costs growing at target consistent rates”.

Indeed, in contrast to the US, where increased productivity caused unit labour costs to fall 0.8% year-on-year in Q1, the combination of lacklustre efficiency gains and rising wages resulted in an equivalent rise of 2.1% year-on-year this side of the Atlantic.

Essentially, whereas below-target inflation in the US and the eurozone is giving both the Fed and the ECB leeway to pre-emptively ease policy to guard against a more protracted economic downturn, the Bank of England does not currently see itself as having such wiggle room. Although Bank of England officials have signalled that a no-deal Brexit would usher in lower interest rates, Governor Carney is still clinging to the view that a smooth Brexit would “require limited and gradual increases in interest rates in order to return inflation sustainably to the 2% target”. Although there is a good chance that the UK economy contracted during Q2, the BoE appears in no hurry to cut rates before the 31 October Brexit deadline.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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