Our Thoughts

UK interest rate rise is coming

The Bank of England’s (BoE) message during its latest inflation report was more hawkish than the markets had expected, highlighting the possibility of a rate hike as early as May.

The decision to raise rates for the Bank has largely hinged on the economic outlook. Subdued growth is what has kept the Bank on hold, despite above-target inflation and a weak GBP.

Why the change in BoE’s stance?

This change in tone from the Bank reflects expectations of slightly stronger growth and less slack compared with November. As such inflation is unlikely to return to the 2% target without some increase in interest rates. The slack refers to the output gap, which is an indicator of the difference between the actual output of an economy and the maximum potential output of the economy. The output gap provides an indication of potential inflationary pressures, because if actual output is greater than potential output there will be inflationary pressures.

The Bank will be hoping that higher interest rates will encourage people to save – a method of curbing inflation.

What will the BoE be assessing?

The BoE has a primary target of price stability – inflation at 2%. That is not the reality so far with the UK inflation breaching the upper tolerance band of 1% above the 2% inflation target. The rise in domestic inflationary pressures is what has prompted the hawkish turn, therefore labour market data releases particularly on wages over the coming months will be key.

The Bank believes UK wage growth will start to pick up, giving the economy a further boost.

Annual average weekly earnings excluding bonuses grew by 2.5% in the fourth quarter of 2017, up from a rate of 2.3% in the previous quarter. Inflation remained at 3%, therefore, while earnings growth may be picking up, people are still not seeing wages rise quick enough to keep up with prices resulting in negative real wage growth. The BoE expects real wage growth to move into positive territory during 2018.

Mixed messages?

The unemployment rate ticked up to 4.4%, up from a 42-year low of 4.3%. Although this was the first increase in unemployment in almost two years, the number of people in work continued to rise over the quarter. There is no evidence yet as to whether the latest figure is a blip or the beginning of an upturn in joblessness. The labour market statistics do however provide mixed messages for the BoE. While an upturn in pay growth opens the door for interest rates to rise, signs of the labour market losing steam add to worries that growth is still fragile.

Real estate implications

Broadly speaking, the UK commercial real estate market appears to be well positioned to absorb a small rise in interest rates. The reason for this is that in property yields have not re-priced to adjust to the very low interest rate environment. Furthermore, current property yield gaps to government bond yields largely provide a cushion in a rising rate environment. It is likely that interest rates will rise gradually, providing the real estate market time to adapt.

For further detail and much more on the UK economy check out the latest Monthly Economic Briefing.