The outlook for global growth has strengthened further. As growth has recovered, spare capacity has diminished, and market interest rates imply some gradual withdrawal of global monetary policy stimulus over coming years. Sustaining current rates of global GDP growth has become increasingly dependent on a recovery in productivity growth.
Global GDP growth picked up during 2016 and has been strong over the past year (Section 1.1). Weighted by countries’ shares of UK exports, global growth is estimated to have remained at 0.8% in 2017 Q4. That pace of growth is expected to persist in the near term, above expectations in November. Survey indicators of output (Chart 1.1) and new orders remain robust, particularly in the euro area and United States. Measures of business and consumer confidence are also healthy. Despite further falls in unemployment across a number of countries, inflation remains subdued relative to historical norms (Section 1.2). There are some signs of a recovery in wage growth, however, and further rises in commodity prices are pushing up global inflation.
In light of the recovery in GDP growth, some monetary policy stimulus has begun to be withdrawn across a number of advanced economies, although policy remains supportive. In November, the MPC raised Bank Rate to 0.5%, which has begun to be passed through to retail lending and deposit rates (see Box 2). Market-implied interest rate paths imply a further gradual tightening in policy over the coming years.
The improvements in global growth and confidence since early 2016 have been an important factor supporting rises in risky asset prices in many countries over that period (Section 1.3). Since late January, however, around the time the MPC’s projections were finalised, equity prices have fallen sharply and volatility in equity markets has risen.(1)
In recent years, four-quarter GDP growth has recovered towards pre-crisis rates in a number of advanced economies (Chart 1.2). That pace of growth has been met largely by increased employment, with productivity growth still subdued. As a result, much of the slack in labour markets that opened up following the financial crisis appears to have been absorbed.
With less remaining slack in labour markets, sustaining the recent pace of global GDP growth has therefore become increasingly dependent on a pickup in productivity growth. Current rates of productivity growth, and shortfalls against pre-crisis trends, differ across advanced economies (Chart 1.3). In particular, euro-area productivity growth had begun to slow prior to the crisis, whereas US and UK productivity growth picked up during the early 2000s before slowing more sharply.2
Productivity growth is expected to recover across advanced economies over coming years, but to remain below pre-crisis rates. Investment spending was reined in following the global financial crisis. That continues to weigh on growth in the capital stock — the resources and equipment available to produce output. Investment growth has begun to recover in many countries, however, which will support growth in the capital stock and productivity.
Quarterly euro-area GDP growth was robust in 2017 and faster than in preceding years, at 0.6%–0.7% (Table 1.A). That pickup in growth has become increasingly broad-based across countries, supported by an improvement in financial conditions, alongside rises in business and consumer confidence. Business survey indicators, such as the IHS Markit purchasing managers’ indices, have risen further in recent months (Chart 1.1). Consistent with that, quarterly GDP growth is projected to be around ¾% in the near term, stronger than projected three months ago (Table 1.B).
The recovery in demand has led to a continuing decline in measures of economic slack. Euro-area unemployment was 8.7% in December, down from 9.7% a year earlier (Chart 1.4), although the extent of the fall in unemployment has varied across countries. As the recent pace of growth continues, unemployment is projected to fall further in the near term.
At 0.6% in 2017 Q4, US GDP growth was broadly in line with expectations three months ago (Table 1.A). Inventories dragged on growth in Q4, which is unlikely to persist. Business surveys point to quarterly growth of around ¾% in 2018 H1 (Chart 1.1). Personal and corporate tax cuts announced in December are expected to provide a stimulus to activity over the next three years. Those cuts are slightly larger, and take effect earlier, than assumed in November, implying additional support to activity in the near term (Section 5).
Indicators suggest that there is probably little spare capacity remaining in the US economy. A variety of measures of labour market slack — including the unemployment rate (Chart 1.4), underemployment and the rate at which employees are voluntarily leaving jobs — are around their pre-crisis levels.
In China, GDP growth continues to be broadly stable (Table 1.A). In 2017 Q4, four-quarter GDP growth was unchanged at 6.8%. Over the past year, activity has been supported by both increased export demand and strong domestic credit expansion. Macroprudential policy measures have led to some slowing in house price inflation and the authorities have continued to take measures to reduce financial sector leverage. There remain challenges for the authorities in maintaining current rates of GDP growth while reducing risks to financial stability.3
Growth in other emerging market economies (EMEs) continued to recover in 2017, supported by: higher capital inflows; the recovery in advanced-economy demand; and, for commodity exporters, the recovery in commodity prices since early 2016. Those factors are expected to underpin slightly stronger growth in EMEs than anticipated in November.
Core inflation — which excludes food and energy prices — remains subdued relative to historical norms in the euro area and United States (Table 1.C). There are some signs of wage growth picking up in those regions, however. And with unemployment set to decline further in the euro area, and seemingly little slack in the United States at present, wage growth and broader inflationary pressures are projected to build over 2018.
Despite subdued core inflation, rises in commodity prices are pushing up headline inflation in the euro area, United States and more widely. As a result, global inflation is a little higher than projected three months ago.
US dollar oil prices have risen fairly steadily since mid-2017, as have industrial metals prices (Chart 1.5). Those rises have in part reflected improvements in global economic activity that have increased demand for commodities. Demand for oil exceeded IEA projections over the second half of 2017, particularly among advanced economies. The rises also reflect supply developments. The supply of oil has risen at a relatively modest pace leading to continued falls in oil stocks. In part, that reflects increased compliance with the late-2016 agreement between OPEC and some non-OPEC oil producers to curb production, which has since been extended to the end of 2018.
By influencing production and transport costs, global commodity prices are also important drivers of the prices of other internationally traded goods. Annual world export price inflation excluding oil is estimated to have slowed to 1.7% in 2017 Q4 (Table 1.C). The more recent rises in commodity prices are, however, set to push up world export prices and therefore UK import price inflation slightly in the near term (Section 4).
In the run-up to the February Report, the sterling ERI was 3% higher than at the time of the November Report, although 16% below its November 2015 peak. The recent rise has largely been relative to the US dollar, which has depreciated against other major currencies. More broadly, sterling has remained around 15%–20% below its pre-referendum peak (Chart 1.6), and has been no more volatile than in previous periods following significant revaluations.
The improving growth outlook has begun to put upward pressure on short-term market interest rates across advanced economies over the past year, as expectations have built that central banks will withdraw some of the stimulus provided by monetary policy. Market-implied paths for policy rates have risen further since November (Chart 1.7).
At its December meeting, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate to between 1¼% and 1½% (Chart 1.7). That was the third 25 basis point increase in the target range during 2017. The median of FOMC members’ projections implies another 75 basis points of tightening during 2018. In addition, and as announced in September, the Federal Reserve’s balance sheet has started to shrink as a proportion of maturing assets are not being replaced.4
The European Central Bank (ECB) has made no changes to its policy rates since November (Chart 1.7). The market-implied path is also broadly flat over 2018. The ECB has continued with its asset purchase programme, although, as announced in October, the pace of purchases has been reduced from €60 billion to €30 billion per month since the beginning of 2018.
In the United Kingdom, the MPC raised Bank Rate to 0.5% in November. In the period when the MPC was finalising its February projections, the market-implied path for Bank Rate reached 0.75% in 2018 Q4 and just under 1¼% in three years’ time (Chart 1.7). The MPC voted to make no changes to monetary policy at its December meeting, as set out in Box 1. The details of the February decision are contained in the Monetary Policy Summary and in more detail in the Minutes of the meeting.
Longer-term interest rates have risen in recent months (Chart 1.8). Those rates had been broadly flat over much of 2017 — albeit at higher levels than in 2016, on average. Although rates were broadly flat, model-based estimates suggest that expected policy rates continued to rise during 2017, but were offset by falls in term premia. Term premia have risen more recently, although they remain relatively compressed. Term premia capture the additional compensation that investors require for holding long-term bonds and therefore reflect market participants’ perceptions of the risks and uncertainties around future interest rates. Market contacts cite the global inflation environment and the prospect of increases in government bond issuance, net of central bank asset purchases, over the coming year as potential sources of the recent rise.
More broadly, continued historically low long-term interest rates in large part probably reflect slow-moving structural factors such as demographics. Those factors are likely to continue to weigh on global interest rates for some time to come.5 Consistent with this, market-implied paths suggest that policy rates will rise by a limited amount in coming years (Chart 1.7), particularly in comparison to previous tightening cycles.
Developments in capital markets influence the ease and cost of raising finance for companies. Equity prices rose sharply in late 2017 and early 2018, particularly in the United States (Chart 1.9). The recently announced US tax cuts (Section 1.1) appeared to boost US equities in particular, while rises in commodity prices (Section 1.2) supported the equity values of companies within the energy sector. Since late January, however, around the time the MPC’s projections were finalised, equity prices have fallen back and volatility in equity markets has risen. Market contacts describe those falls as initially prompted by perceptions of increased inflationary risks.
Equity prices in most countries remain higher than in mid-2016, supported by the improvements in global growth and confidence (Section 1.1). Much of the rise in the FTSE All-Share index over that period (Chart 1.9), however, has reflected the decline in the exchange rate and its impact on the sterling value of profits earned in UK-listed companies’ overseas operations. Consistent with that, the equity prices of UK-focused companies within the index have been broadly unchanged (Chart 1.9).
Despite rises in government bond yields, corporate bond yields have fallen over the past couple of years, reducing the cost of bond financing. The corporate bond spread is therefore lower than in early 2016 (Chart 1.10), particularly for ‘high-yield’ debt, which is issued by companies perceived as riskier. Spreads on riskier high-yield sterling bonds have narrowed by less than their dollar and euro equivalents since early 2016, however.
Capital markets also matter for broader credit conditions through their influence on bank funding costs. Although they have been broadly stable over the past six months, the spreads that banks pay for funding over and above market interest rates have narrowed significantly since early 2016 (Chart 1.11). That narrowing appears largely to have reflected the broader improvement in global financial markets.
To ensure bank lending rates remain closely linked to official policy rates, the Term Funding Scheme (TFS) was introduced in August 2016 to provide funding at close to Bank Rate for lenders that maintained or increased net lending, with a penalty rate for banks that reduced net lending. While the TFS drawdown window will close this month, existing TFS drawings will remain in place for up to four years.
In addition to debt, banks can also raise funds through equity financing, and financial policy can influence the mix of funding. At its November meeting, the Financial Policy Committee (FPC) decided to increase the countercyclical capital buffer rate, levied on banks’ total risk-weighted UK assets, from 0.5% to 1%.6 The setting of the countercyclical buffer will not require banks to strengthen their capital positions. It will require them to incorporate some of the capital they currently have in excess of their regulatory requirements into their regulatory capital buffers.
The narrowing in funding spreads over recent years has contributed to low levels of retail interest rates (Chart B in Box 2). The recent rise in Bank Rate and increases in its market-implied path are expected to feed through gradually into higher rates for households and companies. Nevertheless, overall, bank funding costs and retail interest rates remain low by historical standards.
1. All financial market data shown in charts within this section are to 31 January 2018.
2. For further detail on the factors driving those trends, and for the United Kingdom in particular, see Tenreyro, S (2018), ‘The fall in productivity growth: causes and implications’.
3. For more detail on financial vulnerabilities in China, see the November 2017 Financial Stability Report.
4. For further detail see page 4 of the November 2017 Inflation Report.
5. For further discussion, see the box on pages 8–9 of the November 2016 Inflation Report; Vlieghe, G (2016), ‘Monetary policy expectations and long-term interest rates’; and Vlieghe, G (2017), ‘Real interest rates and risk’.
6. For further detail on the FPC’s decision, see the November 2017 Financial Stability Report.
Survey indicators point to robust advanced-economy growth
Survey measures of international output growth
GDP growth has risen across a number of advanced economies
GDP in the G7 economies
Productivity growth has been subdued across advanced economies in recent years
Euro-area, UK and US productivity (a)
Global GDP growth has been strong in recent quarters
GDP in selected countries and regions (a)
Monitoring the MPC’s key judgements
Unemployment has continued to fall across advanced economies
Euro-area, UK and US unemployment rates (a)
Euro-area and US core inflation rates remain subdued
Inflation and wage growth in selected countries and regions
Oil and industrial metals prices have risen further in recent months
US dollar oil and commodity prices
Sterling has remained 15%–20% below its late-2015 peak
Market-implied paths for short-term interest rates have risen across advanced economies
International forward interest rates (a)
Long-term interest rates have risen slightly in recent months
Five-year, five-year forward nominal interest rates (a)
UK-focused companies’ equity prices have changed little since mid-2016
International equity prices (a)
Corporate bond spreads have narrowed since early 2016
International non-financial corporate bond spreads (a)
UK bank funding spreads have narrowed significantly over the past two years
UK banks’ indicative longer-term funding spreads
The MPC’s central projection in the November Report was for four-quarter GDP growth to pick up from early 2018 and settle around 1¾%. Consumption growth was projected to remain subdued, while strong global growth, together with the lower level of sterling, was expected to support net trade and business investment. Inflation was projected to rise a little further above the 2% target in the near term before falling back over 2018. Conditional on the path for Bank Rate implied by market interest rates prevailing at the time, inflation was projected to end the forecast period slightly above the 2% target. That central projection was also conditioned on the Term Funding Scheme, and on the stocks of purchased gilts and corporate bonds remaining at £435 billion and £10 billion respectively.
At its meeting ending on 13 December 2017, the MPC noted that the recent news in the macroeconomic data had been mixed and relatively limited. Global growth had remained strong, while some indicators of domestic activity in Q4 had softened a little. The measures announced in the Autumn Budget would lessen the drag on demand from fiscal consolidation, relative to previous plans. The labour market remained tight, and the latest surveys suggested this would continue. The impact of November’s rise in Bank Rate on the interest rates faced by households and firms had been consistent with previous experience, but it was too early to form a comprehensive view of its effect on the economy.
CPI inflation had risen to 3.1% in November, slightly higher than the MPC had anticipated at the time of the November Report. The MPC continued to judge that inflation was likely to be close to its peak, and would decline towards the 2% target in the medium term.
All Committee members judged it appropriate to leave the stance of monetary policy unchanged. The MPC was of the view that, were the economy to follow the path expected in the November Report, further modest increases in Bank Rate would be warranted over the next few years, in order to return inflation sustainably to the target. Any future increases in Bank Rate were expected to be at a gradual pace and to a limited extent.
On 2 November 2017, the MPC announced a 25 basis point rise in Bank Rate to 0.5%. There are a number of ways that this tightening in monetary policy will affect the economy. In particular, a change in Bank Rate will affect financial asset prices (Section 1), lending and deposit rates, and therefore households’ and firms’ cash flows and their incentives for saving and borrowing.
Although it is too early to assess fully the implications of the rise in Bank Rate, this box describes the changes in retail interest rates so far, in the context of broader developments in financial conditions. In particular, bank funding spreads have narrowed significantly over the past 18 months (Chart 1.11), putting downward pressure on retail interest rates relative to Bank Rate. Moreover, strong retail competition appears to be continuing to lower interest rates and squeeze banks’ profit margins on some lending products. Nevertheless, retail interest rates have, in general, risen in recent months and are expected to rise slightly further over coming months as the rise in Bank Rate continues to be passed through. The MPC will continue to monitor these rates closely.
Bank Rate is the benchmark around which short-term interest rates in wholesale money markets, and in turn retail interest rates, are determined. The November rise in Bank Rate passed through fully to sterling overnight wholesale interest rates (Chart A). Movements in financial asset prices and interest rates at longer horizons were fairly muted, as market participants had largely anticipated the rise ahead of its announcement. In particular, the market-implied interest rate path had already risen and sterling had appreciated following the publication of the Minutes of the MPC’s September meeting. Overall, in the run-up to the November Report, one and two-year swap rates had risen by 25 basis points and 30 basis points respectively, and they have risen further since (Section 1.3).
Corporate lending rates have risen in recent months (Table 1). Around 85% of bank lending to companies is at a floating rate, typically linked to a short-term market rate. In addition to being passed through to rates on new corporate lending, therefore, pass-through of changes in Bank Rate to the stock of corporate loans tends to be relatively rapid. Accordingly, average rates on outstanding floating-rate corporate loans have risen by around 20 basis points since August.
Quoted rates on lending to households have also risen, as the rise in Bank Rate has begun to be passed through (Table 1). Around 40% of mortgages by value are floating-rate products. The rise in Bank Rate was passed through automatically to ‘tracker’ mortgages, and has also been passed through to other floating-rate products.
The share of fixed-rate mortgages has risen in recent years and is now around 60% by value.7 Interest rates on fixed-rate mortgages are based on longer-term funding costs, which reflect expectations of how Bank Rate will evolve over time. As market-implied interest rate expectations rose in the weeks preceding the rise in Bank Rate, some quoted rates on new fixed-rate mortgages were already increasing ahead of the November announcement.
Retail competition appears to have continued to squeeze banks’ profit margins on some products, pushing down interest rates and offsetting some of the rise in Bank Rate. Indeed, a two-year fixed rate for a new mortgage at 90% loan to value has fallen despite the rise in Bank Rate (Table 1), although these only account for a small share of total lending. That competition, together with a narrowing in bank funding spreads (Chart 1.11), mean that rates on new fixed-rate mortgage products remain significantly lower than 18 months ago. Those past falls mean that many mortgagors have moved onto lower interest rates than they had previously when their fixed rates expired, leading to a fall in effective rates (Chart B).
Rates on other components of household borrowing — such as consumer credit and student loans — are less responsive to changes in Bank Rate and tend to be driven predominantly by other factors. Accordingly, quoted rates on consumer credit have generally changed little since August (Table 1).
Sight deposit rates have typically responded gradually to changes in Bank Rate over the past. Prior to the financial crisis, sight deposit rates were several percentage points below Bank Rate and lending rates. There are limits to the extent to which banks can lower deposit rates, however. So sight deposit rates did not fall as much as Bank Rate during the crisis and in recent years they have been slightly above Bank Rate. As Bank Rate rises, the corresponding rise in deposit rates is therefore likely to be somewhat less. Quoted rates on new household sight deposits have risen slightly in recent months (Table 1). Similarly, the effective rate on sight deposits, which account for around two thirds of the total stock of deposits, has risen by around 10 basis points (Chart B).
Quoted rates for some new time deposits have fallen in recent months (Table 1), although the effective rate on the stock of time deposits has risen a little. Lower quoted rates probably reflect developments in the cost and availability of other sources of bank funding. Indeed, the rates on fixed-rate retail bonds and the rates banks pay to raise funds in financial markets have fallen since early 2016 (Section 1.3).
Households’ and companies’ spending decisions will be affected by their expectations of future interest rates, as well as current rates. According to a recent IHS Markit survey, three quarters of households expect Bank Rate to rise further over the next 12 months (Chart C). The Bank’s Agents also report that businesses expect modest rises in Bank Rate, and 85% of respondents to the latest Deloitte CFO Survey anticipated a rise during 2018.
7. For more details see the box on pages 18–21 of the November 2017 Inflation Report.
The rise in Bank Rate was passed in full to market interest rates
Bank Rate and market interest rates
The rise in Bank Rate has begun to pass through to retail rates
Retail deposit and lending interest rates (a)
Effective mortgage rates are lower than in mid-2016
Bank Rate and selected household effective interest rates
Households expect Bank Rate to rise further
Cumulative distribution of households’ expectations for the timing of the next rise in Bank Rate (a)