The outlook for global activity appears to have moderated slightly and financial conditions have tightened somewhat, particularly in emerging market economies. Growth is expected to remain relatively robust, however. UK financial conditions have tightened slightly, but remain accommodative overall.
Global GDP growth is estimated to have remained broadly stable in 2018 Q2, a little weaker than expected at the time of the May Report, having dipped slightly in Q1 (Table 1.A). Although growth in the US was stronger than expected, activity was somewhat weaker elsewhere.
Indicators suggest that the outlook for global growth has moderated slightly, though remains relatively robust. There are signs of slowing in manufacturing and export-focused sectors (Chart 1.1). Consistent with that, growth in global trade and capital goods orders have also declined (Chart 1.2). Most indicators of activity, however, remain above past averages. Global demand growth is expected to remain at a little under ¾% on a UK trade-weighted basis in Q3, continuing to outstrip potential supply growth.
The resulting gradual absorption of spare capacity in many countries should lead to a rise in inflationary pressures. Having been subdued in recent years, wage growth has picked up in both the US and the euro area (Chart 1.3). Higher oil prices over the past year (Chart 1.4) have also pushed up inflation. Although spot oil prices are broadly unchanged in dollar terms since the May Report, they are around 55% higher than a year ago. That rise in prices largely reflects subdued oil supply, which has been broadly flat since 2016, despite continued oil demand growth. As a result, in 2018 Q1, oil inventories in the US fell to their lowest level since 2015. The rise in oil prices is projected to push up world export price inflation in the near term.
Diminishing spare capacity and rising inflation will have implications for monetary policy. In the US, the Federal Open Market Committee (FOMC) has continued to tighten policy (Section 1.2). Monetary policy in a number of emerging market economies (EMEs) has also been tightened modestly, as central banks in those countries have responded to the resulting appreciation in the US dollar and reduced demand for EME assets (Section 1.3).
Monetary policy is one factor that has tightened global financial conditions. A summary measure of financial conditions suggests that, having eased substantially during 2016–17 as investor confidence and risk appetite rose, conditions have tightened over 2018 so far (Chart 1.5). Financial conditions remain accommodative, however, relative to past averages. Within that, conditions in emerging markets have tightened by more than elsewhere, and so activity is likely to be dampened in those countries most (Section 1.3). In the UK, the slight tightening in financial conditions will push up the cost of financing for households and businesses modestly (Section 1.4).
In addition to monetary policy, some of the tightening in financial conditions appears to reflect a rise in geopolitical uncertainty, with market contacts reporting a modest deterioration in global risk sentiment among investors. There were sharp falls in Italian asset prices following political developments there, although other euro-area asset prices were less affected. There are also signs of rising trade protectionism globally. Tariffs applied by the US on US$50 billion of Chinese imports, to go alongside the aluminium and steel tariffs announced earlier in the year, have been met with reciprocal measures. And around US$200 billion of Chinese goods have been identified by the US as potentially subject to further tariffs.
Uncertainty around tariffs and the resulting impact on trade has led to falls in some equity indices, particularly in emerging markets. Some non-oil commodity prices have also fallen, particularly for metals (Chart 1.4), which market contacts report reflected concern around the effect of higher trade tariffs on demand. However, that uncertainty has not yet been reflected in indicators of consumer and business confidence which, on the whole, have remained relatively robust in the euro area and US (Chart 1.6).
Tighter financial conditions are likely to dampen growth, as are greater barriers to trade. The direct impact of the higher tariffs that have been implemented or proposed on bilateral trade between the US and China and any associated reciprocal measures, as well as wider aluminium and steel tariffs, will weigh somewhat on activity in those countries in coming quarters, and elsewhere to a modest extent. Moreover, the prospect of a further escalation in trade protectionism — particularly if business and consumer confidence and financial conditions were to deteriorate materially — could weigh further on the global outlook.1
Overall, global growth is expected to remain relatively robust over the next year (Table 1.B), gradually pushing up inflation. That pace of growth, however, is a little slower than projected at the time of the May Report, reflecting slightly tighter financial conditions and some direct effects from higher trade tariffs (Section 5).
Global GDP growth was broadly stable in Q2
GDP in selected countries and regions(a)
Global export orders growth slowed sharply
Global purchasing managers' indices(a)
Growth in trade and capital goods flows slowed in Q2
World trade in goods and euro-area and US capital goods orders
Euro-area and US wage growth have picked up
Euro-area and US wages
Metals prices have fallen
US dollar oil and commodity prices
Global financial conditions have tightened but remain accommodative overall
Financial conditions indices(a)
Measures of euro-area and US confidence remain robust
Euro-area and US consumer and business confidence(a)
Monitoring the MPC's key judgements
Quarterly GDP growth in the euro area averaged 0.4% during the first half of the year (Table 1.A). That was lower than anticipated in May and lower than in 2017, when growth averaged 0.7%. That slowdown probably partly reflected temporary factors, including adverse weather in some northern European countries in Q1, particularly Germany and France. And the synchronicity of the slowdown in demand in Q1 globally — reflected in weak export growth — may have pushed up inventories that quarter, so companies may not have had to increase output in Q2 to meet final demand, even as it recovered.
Underlying demand growth in the euro area appears to have remained relatively robust, however. Quarterly consumption growth was 0.5% in Q1, a little stronger than 2017 rates, while both consumer and business confidence remained strong. That should support euro-area activity in coming quarters.
The strength of demand growth over the past two years has steadily reduced the degree of slack in the euro area, but some spare capacity is judged to remain. The unemployment rate, at 8.3% in June (Chart 1.7), is above its estimated equilibrium rate — the rate consistent with stable wage pressures. As set out in the November 2017 Report, that equilibrium rate is likely to have fallen in recent years, reflecting the impact of labour market reforms in a number of countries. Consistent with that, although wage growth has picked up since 2016 (Chart 1.3), unit labour cost growth has not increased to the same degree. Core inflation has also remained relatively subdued (Table 1.C). Taken together, that suggests that the economy is still operating some way below full potential.
The European Central Bank (ECB) made no changes to its policy rates in June or July, and provided guidance in June that rates were expected to remain at present levels at least through the summer of 2019. The ECB also announced an extension to its asset purchase programme to December 2018, at a slower rate of €15 billion per month, reduced from €30 billion currently, and anticipated an end to net purchases after that date, subject to incoming data.
The announcement in June led to a shift down in the market‑implied path for policy rates (Chart 1.8), while longer‑term interest rates also fell slightly (Chart 1.9). Despite the lower path for policy rates, financial conditions in the euro area are a little tighter than in May, in part reflecting the slight deterioration in global risk sentiment. Euro-area equity prices are slightly lower (Chart 1.10) while euro-denominated corporate bond spreads have widened (Chart 1.11).
With underlying demand growth still relatively robust, quarterly euro-area activity growth should pick up slightly in the second half of 2018, to around ½% on average. That outlook is slightly weaker than was projected at the time of the May Report, in part reflecting tighter financial conditions, the moderation in global activity and small spillover effects from tariff increases on US-China bilateral trade. These factors are expected to weigh particularly on net trade, which had contributed substantially to euro-area growth in 2017.
Unemployment remains elevated in some euro-area countries
Unemployment rates in selected euro-area economies(a)
Core inflation has picked up in the US, but remains subdued in the euro area
Inflation in selected economies
The paths for interest rates have flattened slightly in the UK and euro area
International forward interest rates(a)
Longer-term interest rates have fallen slightly
Five-year, five-year forward nominal interest rates(a)
EME equity prices have fallen since the start of the year
International equity prices(a)
Corporate bond spreads have widened since May
International non-financial corporate bond spreads(a)
In contrast to the euro area, activity in the US — the UK's second largest trading partner — rebounded strongly from a dip in growth in Q1, expanding by 1% in Q2. As expected, consumption growth rose in Q2 (Chart 1.12), probably reflecting the delayed timing of personal tax refunds shifting spending from Q1 into Q2. The recovery in activity was stronger than expected in May though, driven by a bigger contribution from net trade. That largely reflected erratically strong export growth in certain sectors.
GDP growth is expected to fall back in Q3 as the erratic boost from net trade unwinds, but to remain robust at around ¾% (Table 1.B). Activity will be supported thereafter by fiscal policy, following the personal and corporate tax cuts announced in December 2017, as well as the Bipartisan Budget Act of 2018, which lifted discretionary spending caps by around US$300 billion over 2018 and 2019, equivalent to around 1.5% of GDP. Offsetting that slightly, the higher tariffs that have been implemented or proposed on US trading partners, including China, and associated reciprocal measures, will weigh somewhat on activity growth.
Strong demand growth in recent years has absorbed spare capacity in the US economy, with little, if any, slack remaining. Employment growth has remained solid and the unemployment rate fell in 2018 Q2 to 4.0%, around its lowest level since 2000. Other measures of labour market slack, such as underemployment and the rate at which employees are voluntarily leaving jobs, are around their pre-crisis levels. As the labour market has tightened, annual wage growth has risen (Chart 1.3), which is likely to have contributed to a pickup in core inflation (Table 1.C).
Reflecting the robust outlook for demand and rising inflation, the FOMC has continued to tighten policy, raising the target range for the federal funds rate to between 1¾% and 2% in June. The median projection of FOMC members for the federal funds rate at end-2018 also rose from 2.1% to 2.4%, implying two further 25 basis point increases in 2018, with a further three projected in 2019. That is a slightly steeper path for policy than implied by market prices (Chart 1.8).
As announced in September 2017, the Federal Reserve has continued to reduce its balance sheet by not replacing a proportion of maturing assets. By late July, the balance sheet had shrunk by around US$170 billion. Reduced reinvestment of past asset purchases, together with the prospect of rises in US government debt issuance following recent tax reforms, could put some upward pressure on longer-term interest rates. Longer-term rates have not yet picked up materially (Chart 1.9), however, and remain close to historically low levels. That may reflect the offsetting effect of FOMC communications, which have emphasised that, to the extent that a shrinking balance sheet tightens monetary conditions, the federal funds rate would be commensurately lower.2 Recent capital flows into safe assets in the US as global risk sentiment has deteriorated may also have put downward pressure on longer-term rates. And, as discussed in Box 6, slower-moving structural factors, such as demographics, are likely to continue to weigh on global long-term interest rates for some time.
The FOMC's gradual policy tightening has begun to feed through to US financial conditions. Rates on shorter-term consumer credit have risen steadily, although the cost of mortgages — the majority of which are fixed for 30 years — has picked up by less, consistent with the more limited rise in longer-term rates. Since the May Report, US equity prices have risen (Chart 1.10), however, while corporate bond spreads have been broadly unchanged (Chart 1.11), contrasting with asset price moves elsewhere. Market contacts suggest that higher interest rates and the robust US growth outlook have led to a strengthening of the US dollar which has appreciated by around 5% over the same period on a trade-weighted basis (Chart 1.13).
US GDP growth picked up sharply in Q2, driven by net exports and consumption
Contributions to quarterly US GDP growth(a)
EME currencies have depreciated since May
Effective exchange rates
In aggregate, GDP growth in China and other EMEs has remained relatively robust. The outlook for growth, however, is a little weaker than in the May Report (Table 1.B). The growing prospect of trade protectionism has contributed to falls in equity and corporate bond prices in some countries according to market contacts, which will weigh on activity to some degree. And US monetary policy tightening has also led to a tightening in EME financial conditions.
Having slowed slightly in Q1, quarterly GDP growth in China increased to 1.8% in Q2 (Table 1.A), a stronger pickup than expected in May. The prospect of rising barriers to trade with the US has weighed on asset prices however. The Shanghai Composite equity index is 9% lower than at the time of the May Report (Chart 1.10) and the renminbi has depreciated (Chart 1.13), driven by a 6% fall against the US dollar. The direct impact of tariff changes that have been implemented or proposed so far is judged to weigh on the outlook for activity but that effect is likely to be relatively small.
Expansionary fiscal policy and continued robust credit growth are expected to support activity in the near term. Survey indicators, such as the Caixin composite PMI, point to continued robust growth. And measures of consumer and business confidence have remained stable in recent months. As discussed in the June Financial Stability Report, however, there remain challenges for the Chinese authorities in maintaining current rates of GDP growth while reducing risks to financial stability. A sharp slowdown in China could have a material impact on the UK, both directly and indirectly through trade and financial linkages, and that effect could be amplified by large exchange rate and asset price reactions.3
As a whole, activity growth across non-China EMEs was broadly stable in 2018 Q1, but with differences between countries. A slowdown in some countries, such as Brazil and Indonesia, was offset by stronger growth elsewhere. Survey indicators, such as Markit PMIs, have fallen slightly, however, and point to a slowdown in aggregate activity growth in the near term. Non-China EMEs in aggregate account for around 18% of UK trade and, as discussed in the Financial Stability Report, disruption in those economies could also have a material impact on the UK via financial conditions and spillovers through other advanced economies.
One factor that is likely to weigh on non-China EME growth over coming quarters is the tightening in US monetary policy. EME financial conditions tend to be sensitive to US financial conditions, in part as some EMEs have high levels of government or corporate debt denominated in dollars. Around 26% of non-China EME non-financial corporate debt is dollar denominated, equivalent to around 12% of nominal GDP, with particularly large concentrations in South America and Turkey. Unless borrowers have revenues in US dollars, or have hedged themselves against exchange rate moves, those debts become costlier to service if the US dollar appreciates, as it has done against nearly all major EME currencies in 2018 so far.
In addition, absent a change in policy rates in EMEs, tighter US policy rates will reduce the relative return on EME assets and, in turn, external demand for those assets. The reduction in demand for EME assets has been exacerbated by rising trade uncertainty, with the integration of many EMEs into global supply chains exposing them to the effects of potential trade disruption. And in the case of some countries, such as Argentina, Brazil and Turkey, institutional and political developments may have further reduced investor demand for their assets.
Perhaps reflecting that, there was a net outflow of portfolio capital from EMEs in Q2 (Chart 1.14). EME equity prices have fallen this year (Chart 1.10), while government and corporate bond spreads have widened. To support exchange rates and capital inflows, a number of EME central banks have increased their policy rates, further tightening financing conditions in those countries. Overall, EME growth is projected to slow over 2018, as tighter financial conditions weigh on activity. That tightening in financial conditions, however, follows a period of substantial easing during 2016–17 (Chart 1.5).
Net portfolio capital flows into EMEs were negative in Q2, and bond spreads widened
EME net portfolio capital inflows and government and corporate bond spreads
Global developments will affect the UK through their impact on external demand (Section 2), and by influencing UK asset prices and the financial conditions facing UK households and companies. The tightening in global financial conditions has pushed up the cost of finance in the UK modestly, both in capital markets and, by raising the cost of bank funding, through bank lending.
At its June meeting, the MPC voted 6–3 to leave Bank Rate unchanged and unanimously to maintain the stock of purchased assets. The majority of the MPC judged that, although news since May had given them greater reassurance that the softness of activity in 2018 Q1 had been largely temporary, there was value in seeing how the data continued to evolve, given signs of a weaker global outlook and tightening in global financial conditions. As discussed in Box 1, the MPC also revised its guidance on the level of Bank Rate at which it would consider starting to reduce the stock of purchased assets, reducing that level to around 1.5%, compared to the previous guidance of around 2%.4
Since the run-up to the May Report, UK interest rates have fallen. The market-implied path for Bank Rate in the run-up to the August Report reached 1.1% in three years' time, just over 10 basis points lower than in May (Chart 1.8). Over the same period, the sterling ERI was 2½% lower (Chart 1.13), and 17% below its late-2015 peak. Market contacts suggest that sterling has remained sensitive to shifts in perceptions of the UK's future trading relationships following Brexit and their implications for the economy.
UK equity prices have picked up slightly (Chart 1.10), as the depreciation in sterling since the run-up to the May Report increased the value of profits earned by UK-listed companies' overseas operations. The depreciation in sterling has been a significant driver of UK equity prices since the start of 2016, with the FTSE All-Share index around 25% higher over that period. The equity prices of predominantly UK‑focused companies are broadly unchanged (Chart 1.10).
Spreads on corporate bonds — another significant source of finance for large companies — have widened over the past few months (Chart 1.11). That has raised the cost of finance, although, as discussed in the latest Financial Stability Report, spreads remain at levels comparable with those seen before the financial crisis. Since the May Report, spreads on sterling investment-grade and high-yield bonds have risen by around 15 basis points and 60 basis points respectively, while spreads on euro-denominated bonds — an important funding market for UK companies — have widened to a similar degree. Alongside shifts in global risk sentiment, market contacts have cited a number of additional drivers of the recent widening in bond spreads including the prospective end of the ECB's corporate bond purchase programme and recent US corporate tax reform, which has encouraged share buybacks among US companies and may have reduced demand for European debt.
Global developments can also affect bank borrowing costs for households and corporates, primarily by affecting the cost of wholesale bank funding. Spreads on bank debt funding have picked up materially over 2018 (Chart 1.15), back to around their average level since 2014. In part, that rise appears to have been driven by the same factors that have pushed up spreads in corporate bond markets more generally. In addition, as discussed in the latest Financial Stability Report, stronger bank debt issuance than in recent years, in part as banks look to meet incoming regulatory requirements, has also added to the upward pressure on funding spreads.
The cost of wholesale funding is one factor affecting the rates that banks are willing to pay on retail deposits. Deposit rates have picked up alongside wholesale funding spreads in recent months (Chart 1.15). Some quoted deposit rates, in particular on shorter-term products, remain lower than they were in 2016 however (Table 1.D). As discussed in Box 4 of the February Report, those shorter-term deposit rates were some way below Bank Rate prior to the crisis and so as Bank Rate subsequently fell to very low levels, deposit rates fell by less. As such, since the rise in Bank Rate in November, the corresponding rise in deposit rates has been somewhat less, as the spread between deposit rates and Bank Rate has begun to return to more normal levels.
Borrowing rates facing households have remained relatively low, though some mortgage rates have picked up slightly in recent months (Table 1.D). Higher bank funding spreads, alongside the upward-sloping market-implied path for interest rates, are likely to push up household borrowing rates in the near term. The strength of competition in the retail banking market in the face of relatively subdued demand for household credit has pushed down lending rates in recent years, with lenders reducing margins on some products to maintain market share. Lenders noted in recent discussions that, although further compression as a result of competition was unlikely, margins on lending were not expected to pick up materially.
For companies, bank borrowing rates have been broadly stable since May (Table 1.D), having picked up gradually since August last year as rises in short-term market interest rates were passed through to lending rates. As most lending to companies is agreed at a floating rate, those rises were passed through fairly quickly to the stock of corporate borrowing.
1. For more details see Carney, M (2018), 'From protectionism to prosperity'.
2. For more details see Broadbent, B (2018), 'The history and future of QE'.
3. For more detail on the linkages between China and the UK economy, see Gilhooly, R, Han, J, Lloyd, S, Reynolds, N and Young, D (2018), 'From the Middle Kingdom to the United Kingdom: spillovers from China', Bank of England Quarterly Bulletin, 2018 Q2.
UK bank funding spreads have widened in recent months
UK banks' indicative funding spreads
Household borrowing rates have remained low
Retail interest rates on lending and deposits(a)
The MPC's central projection in the May Report was for GDP to grow by around 1¾% per year on average over the forecast period. While modest by historical standards, that growth rate was slightly faster than the diminished rate of supply growth, which was projected to average around 1½% per year. As a result, a small margin of excess demand was projected to emerge by early 2020, feeding through into higher rates of pay growth and domestic cost pressures. Nevertheless, CPI inflation was projected to continue to fall back gradually as the effects of sterling's past depreciation faded. Conditional on the path for Bank Rate implied by market interest rates prevailing at the time, inflation was projected to reach the 2% target in two years.
A key assumption in the MPC's May projections was that the dip in output growth in the first quarter of 2018 would prove temporary. At its meeting ending on 20 June 2018, the MPC noted that recent data releases had been broadly consistent with that judgement. A number of indicators of household spending and sentiment had bounced back strongly, employment growth had remained solid and surveys of business activity had been stable. Global activity data had been mixed, however, and downside risks had increased in some emerging markets, although the prospects for global GDP growth remained strong.
CPI inflation had remained unchanged at 2.4% in May. In the near term, inflation was expected to pick up by slightly more than projected in the May Report, reflecting higher dollar oil prices and a weaker sterling exchange rate. Most indicators of pay growth had picked up over the past year and the labour market remained tight, suggesting that domestic cost pressures would continue to firm gradually.
The best collective judgement of the MPC remained that, were the economy to develop broadly in line with the May Report projections, an ongoing tightening of monetary policy would be appropriate to return inflation sustainably to its target at a conventional horizon. All members agreed that any future increases in Bank Rate were likely to be at a gradual pace and to a limited extent.
Six members judged that an increase in Bank Rate was not required at the June meeting. While the news since the previous meeting had given these members greater reassurance that the softness of activity in the first quarter had been largely temporary, the outlook for global growth had weakened somewhat and global financial conditions had tightened. For these members, there was value in waiting to see how the data evolved.
Three members favoured an immediate increase in Bank Rate of 25 basis points. These members had a higher degree of confidence that the slowdown in Q1 was temporary or erratic, and felt that the most recent labour market indicators indicated some upside risks to the expected pickup in average weekly earnings and unit wage costs.
In addition to its discussion of the immediate policy decision, the MPC reviewed its previous guidance on the level of Bank Rate at which it would consider whether to start to reduce the stock of purchased assets. The MPC continues to expect to maintain the stock of purchased assets until Bank Rate reaches a level from which it can be cut materially. Since its previous guidance, however, the MPC had reduced Bank Rate from 0.5% to 0.25% and had noted that it could be lowered further if required. Reflecting this, the MPC now intends not to reduce the stock of purchased assets until Bank Rate reaches around 1.5%, compared to the previous guidance of around 2%. Consistent with its previous guidance, a decision to start reducing the stock of purchased assets would reflect the economic circumstances at the time.