Published on 10 May 2018
Published on 10 May 2018
Although momentum in global activity has eased slightly since the start of the year, growth remains robust. The recovery in global growth since 2016 has meant that spare capacity in advanced economies has diminished and, in some countries, inflationary pressures have begun to rebuild. Global financial conditions remain accommodative, despite a rise in short-term interest rates and, more recently, a fall in equity prices.
Global GDP growth has picked up since 2016. While the pace of activity weighted by countries' shares in UK exports slowed slightly in Q1 (Table 1.A), a good part of that slowing appears to have reflected temporary factors such as adverse weather conditions. Geopolitical developments, including the prospect of trade tariffs, appear to have weighed on risky asset prices. To the extent that also contributed to the weakening in survey measures of global output growth since the start of the year, those indicators may overstate the slowing in growth. Global GDP growth is projected to pick back up in Q2, and to be robust over the remainder of 2018 (Section 1.1).
As global growth has strengthened, spare capacity has diminished and inflationary pressures in some countries have begun to rebuild (Section 1.2). That has been particularly apparent in the US, where core inflation and wage growth have both risen in recent months. Wage growth has also firmed in the euro area, albeit from subdued rates.
Consistent with these emerging signs of inflationary pressures, investors now appear to be putting less weight on the possibility of very low levels of future inflation. Short-term interest rates in some countries have risen in recent quarters as expectations of the degree to which central banks will need to tighten monetary policy in response have increased. Financial conditions nevertheless remain accommodative (Section 1.3).
UK-weighted GDP growth slowed slightly in Q1
GDP in selected countries and regions(a)
The strengthening in advanced-economy growth since 2016 has been accompanied by a pickup in investment growth (Chart 1.1). By adding to the capital stock, that should boost the supply capacity of those countries and support the outlook for global activity further ahead. World trade growth has also strengthened over the past 18 months, having been subdued in the years following the crisis (Chart 1.2). That pickup has been broad-based across both advanced and emerging market economies and has been an important driver of the recent strength in UK export growth (Section 2).
The strengthening in global growth over the past two years has been accompanied by a marked easing in financial conditions as investor confidence and risk appetite have increased. International equity prices have risen sharply over that period (Chart 1.3) and implied equity volatilities, indicators of investor uncertainty, reached historical lows at the end of 2017 (Chart 1.4).
Around the time of the February Report, equity prices fell back somewhat (Chart 1.3) and implied volatility levels rose (Chart 1.4) as financial market participants appeared to reassess the outlook for inflationary pressures in the US (Section 1.2). Although equity prices partially recovered following that episode, geopolitical developments and concerns over the outlook for companies' medium-term earnings amid the prospect of higher interest rates are reported to have weighed on these prices in recent weeks.
One important geopolitical development has been the prospect of a rise in trade protectionism. In March, the US government announced that it would impose tariffs on imports of steel and aluminium of 25% and 10% respectively. Further tariffs have since been proposed by both the US and China. By raising the cost of imported goods, tariffs tend to push up prices and reduce demand. The direct impact of the tariffs announced so far is likely to be very small, since the goods affected account for only a small share of bilateral trade between the two countries. But there is a risk that a further rise in trade protectionism could reduce global activity and push up inflation in those countries by more.
Quarterly euro-area GDP growth slowed to 0.4% in Q1 (Table 1.A), 0.4 percentage points weaker than expected in February. A good part of that weakness appears to have been caused by particularly bad weather in some northern European countries. Business and consumer confidence measures (Chart 1.5) and the composite PMI indicator of output growth have fallen since the start of the year, although they remain above their long-term averages.
Quarterly GDP growth is expected to recover somewhat in Q2 as the weakness caused by adverse weather unwinds. Growth is projected to be a little above ½% per quarter in the near term (Table 1.B), supported by above-average consumer and business confidence as well as accommodative credit conditions.
Quarterly US GDP growth was 0.6% in 2018 Q1, weaker than expected in February. Some of that downside news is likely to be temporary, reflecting factors such as changes in the timing of tax refunds. Output surveys, and measures of consumer and business confidence (Chart 1.5), remain above past averages and growth is projected to be robust in the near term at close to ¾% per quarter (Table 1.B).
US GDP growth will be supported by 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. Together these measures are expected to contribute towards a rise in the US budget deficit. The Congressional Budget Office projects the deficit to rise from 3.5% of GDP in fiscal year 2017 to 4.6% in 2019.
GDP growth in China slowed in Q1 (Table 1.A) but is expected to pick back up in Q2. Expansionary fiscal policy, robust credit growth and the strength in global demand growth are expected to support activity in coming quarters. The outlook for growth is little changed since February, and the authorities continue to face challenges in maintaining the pace of GDP growth while reducing risks to financial stability.
Activity across other emerging market economies (EMEs) was slightly weaker in 2017 Q4 than expected in February, but survey indicators continue to point to strong growth in the near term. Countries with large US dollar-denominated debts and high external financing requirements are, however, potentially vulnerable to a sharper-than-expected rise in US interest rates or a stronger US dollar exchange rate, and private sector capital flows to EMEs recently turned from a net inflow to a net outflow. While these developments could weigh on activity growth, the rises in commodity prices since mid-2017 (Section 1.2) should support growth for commodity exporters over the coming quarters.
The composition of advanced-economy growth has rotated towards investment
Contributions to four-quarter GDP growth for selected advanced economies(a)
Global trade growth has picked up in recent quarters
Global GDP and trade in goods
International equity prices have fallen somewhat in recent months
International equity prices(a)
Financial market based measures of uncertainty rose sharply in February but have fallen back since
Implied volatilities for euro-area and US equity prices
Measures of euro-area and US confidence remain robust
Euro-area and US consumer and business confidence(a)
Monitoring the MPC's key judgements
Global inflation has been subdued in recent years. Much of that is likely to have reflected the economic slack that opened up within countries following the financial crisis. Even as demand started to recover, that slack meant that inflationary pressures remained relatively weak.
The strength of global demand has led to much of that slack being absorbed. In the US, both unemployment and broader measures of spare capacity, such as underemployment, have fallen in recent years. And estimates from statistical filters, which estimate potential supply using past observations of GDP, inflation and unemployment, suggest that little, if any, spare capacity remains. As spare capacity has been absorbed, core inflation and wage growth in the US have picked up (Table 1.C) and the weight placed by investors on the risk of very low inflation appears to have fallen (Chart 1.6).
While slack has also diminished in the euro area, statistical estimates suggest that some spare capacity remains. Euro-area wage growth picked up slightly in 2017 in response to the reduction in slack, although core inflation remains subdued (Table 1.C).
Inflation can also be influenced by global factors through their impact on export prices.1 As the proportion of demand accounted for by imported goods and services has risen steadily over time, the importance of these global channels for inflation is likely to have increased.
Highly tradable goods such as commodities exert a particularly strong influence on inflation rates. Oil and metals prices have picked up sharply since mid-2017 ( Chart 1.7 ). Consumption of both oil and metals tends to be closely related to world activity and part of that rise in prices is likely to have reflected the strength in global demand, against a backdrop of modest supply growth. Commodity prices have been volatile in recent months, predominately reflecting supply factors and geopolitical developments, including the introduction of US sanctions on Russia which has led to sharp fluctuations in the price of aluminium. Overall, rises in the prices of commodities over the past year are projected to push up world export price inflation in the near term and by a little more than in February, although world export price inflation is projected to slow in subsequent quarters.
As inflationary pressures in some countries have begun to emerge, expectations of future official interest rates have risen.
In the US, the Federal Open Market Committee raised the target range for the federal funds rate to between 1½% and 1¾% at its March meeting, and left policy unchanged in May (Chart 1.8). The market-implied path has risen by around ¼ percentage point since the February Report, and suggests a ¾ percentage point rise in the policy rate over the next year. In addition, as announced in September 2017, the Federal Reserve's balance sheet has been shrinking gradually as a proportion of maturing assets are not replaced. As a result, its balance sheet had shrunk by around US$100 billion by early May.
The European Central Bank (ECB) has made no changes to its policy rates since February, and the market path implies a gradual rise in policy rates from 2019 onwards ( Chart 1.8 ). As announced in October, while the ECB is continuing its asset purchase programme until at least September 2018, it has reduced the pace of purchases from €60 billion to €30 billion per month since the beginning of 2018.
At its March meeting, the MPC voted 7–2 to leave Bank Rate unchanged and unanimously to maintain the stock of purchased assets (see Box 1). The MPC judged that, given the prospect of excess demand over the forecast period, an ongoing tightening of monetary policy would be expected to be appropriate over the next three years in order to return inflation sustainably to the 2% target. In the run-up to the May Report, the market-implied path for Bank Rate reached 1¼% in three years' time, slightly higher than in the run-up to the February Report (Chart 1.8). That path continues to imply that future rises in Bank Rate will be gradual relative to past tightening cycles (Chart 1.9). The MPC's May decision is described in the Monetary Policy Summary and in more detail in the Minutes of the meeting.
Longer-term interest rates are close to their levels in the run-up to the February Report in the UK, Germany and France (Chart 1.10). They have risen slightly in the US, however, which market contacts report may be partly due to a projected increase in government bond issuance (Section 1.1) net of central bank asset purchases. Between late 2013 and 2017, government bond issuance in major advanced economies broadly matched purchases of government debt by central banks. But lower volumes of asset purchases, combined with projected rises in US government debt issuance, will raise the stock of government bonds that needs to be held by private investors. All else equal, that is likely to be pushing up the required yields on those bonds and hence longer-term interest rates. Overall, however, longer-term rates remain at historically low levels, largely reflecting slow-moving structural factors such as demographics. These factors are likely to continue to weigh on longer-term rates for some time.2
1. There are a number of other global channels that may affect inflation. For example, the integration of lower-cost producers into the global economy and the increased importance of global labour pools for domestic supply may have reduced inflation for advanced economies. For more details, see Carney, M (2017), '[De]Globalisation and inflation'.
2. For further discussion, see the box on pages 8–9 of the November 2016 Inflation Report ; and Vlieghe, G (2016), ' Monetary policy expectations and long-term interest rates '.
Wage growth and core inflation have picked up in the US
Inflation and wage growth in selected economies
The weight placed on the risk of very low US CPI inflation has fallen
Option-implied weight on US CPI inflation three years ahead (a)
Oil and metals prices have risen over the past year
US dollar oil and commodity prices
The market-implied path for US short-term interest rates has risen
International forward interest rates(a)
Market prices imply a gradual tightening cycle relative to the past
UK Bank Rate tightening cycles(a)
Longer-term interest rates have risen slightly in the US since the run-up to the February Report
Five-year, five-year forward nominal interest rates(a)
Bank Rate was raised to 0.5% in November and the path of short-term interest rates has steepened since then. Much of that rise has been passed through to the borrowing rates facing households and companies, many of which have risen in recent months. Most borrowing rates for households remain lower than in mid-2016, however, as spreads have narrowed. That narrowing has reflected a rise in global risk appetite and the stronger outlook for global growth, which reduced the cost of bank funding relative to policy rates in the UK and many other countries during 2016–17, as well as strong competition between lenders in the face of subdued demand for credit in the UK.
Borrowing costs for households and companies are projected to rise gradually further in coming years. The market-implied path for Bank Rate remains upward sloping and bank funding costs, over and above those market rates, have risen in recent months, unwinding some of the compression since 2016. This will feed through gradually to higher retail interest rates. Nevertheless, credit conditions are likely to remain accommodative, and this will support the outlook for consumption and business investment (Section 5).
As explained in Box 2, an important component of the interest rates facing households and companies is the cost of bank funding. During the financial crisis, the spread between reference rates and bank funding costs rose sharply as investors demanded higher compensation for the risks associated with providing funding to banks (Chart 1.11). These higher funding spreads meant that the interest rates banks charged for household borrowing fell by significantly less than Bank Rate over this period.
In the years following the crisis, funding spreads narrowed as banks repaired their balance sheets and became more resilient. Central bank policies also helped to improve conditions over this period. The Bank's Funding for Lending Scheme, which began in 2012, provided funding at rates closer to Bank Rate and incentivised banks to increase lending.3 In addition, the ECB's longer-term refinancing operations — which provided finance directly to euro-area banks beginning in late 2011 — led to an improvement in sentiment in UK bank funding markets, and some UK banks raised funds directly from these operations through their foreign subsidiaries.
Since mid-2016, a rise in global risk appetite and the stronger outlook for activity (Section 1.1) have seen investors more willing to provide funding for banks, which has helped drive wholesale unsecured funding spreads narrower still (Chart 1.11). The Term Funding Scheme, which enabled banks to draw down funding between August 2016 and February 2018 at rates close to Bank Rate for a period of four years, may also have contributed to the narrowing in funding spreads over this period, although the effect is estimated to be relatively small.
Spreads on wholesale unsecured funding have widened slightly since February, although they remain tight (Chart 1.11). That widening appears to reflect a shift in the balance of supply and demand for bank debt. Market contacts have cited a number of drivers of the recent moves in both short and longer-term funding spreads, including: a rise in US Treasury bill issuance; higher bank debt issuance in response to regulatory changes; the prospective end of the ECB's corporate bond purchase programme; and recent US corporate tax reform, which has reduced the demand for bank debt and encouraged greater share buybacks among US companies. These developments have been most acute in the US dollar funding market — where Libor-OIS spreads, in particular, have widened sharply — but they appear to have affected funding spreads more broadly as banks compete globally for funding. Wholesale funding spreads for UK banks are projected to widen slightly further in coming years.
Banks also fund their lending through deposits. In contrast to the widening in wholesale funding spreads, spreads on both time (Chart 1.11) and sight deposits have fallen in recent months. As discussed in Box 2 of the February Report, sight deposit rates were some way below Bank Rate prior to the crisis. Since there are limits to the extent that deposit rates can be lowered below 0%, deposit rates fell by less than Bank Rate during the crisis. Since the rise in Bank Rate in November, the corresponding rise in deposit rates has therefore been somewhat less as the spread between deposit rates and Bank Rate has begun to return to more normal levels.
The compression in bank funding spreads during 2016–17 contributed to a narrowing in spreads on household borrowing rates (Chart 1.12). A weighted average of spreads on new household mortgage rates has fallen by a little under 1 percentage point since mid-2016. Spreads on personal loan rates have also narrowed over that period.
Besides the compression in bank funding spreads, another factor that may have contributed to the narrowing in spreads on retail interest rates is the strength in competition between lenders in the face of relatively sluggish demand for credit. Lenders noted in recent discussions that profit margins for low loan to value (LTV) products were squeezed, and that competition has intensified over the past six months in the market for high LTV mortgages where margins were wider.4
That narrowing in credit spreads has meant that many household borrowing rates remain significantly lower than in mid-2016, even after rises in short-term interest rates in recent months have been passed through (Table 1.D). That has allowed many mortgagors to remortgage to lower interest rates than they had previously, so effective rates on the existing stock of household borrowing have fallen since mid-2016 (Chart 1.13). Rates on personal loans have also decreased markedly since mid-2016 and have changed little in recent months, although there is evidence of a tightening in consumer credit conditions as a whole over the past year (Section 2).
The upward-sloping market-implied path for short-term interest rates and recent rises in bank funding spreads are expected to feed through gradually into a further rise in household borrowing rates over time. Lending conditions are nevertheless projected to remain relatively accommodative and supportive of consumption growth ( Section 2 ).
Bank lending rates for companies have risen since August 2017 (Table 1.D), mainly reflecting rises in short-term market interest rates. Since most lending to companies is agreed at a floating rate, those rises were passed through fairly quickly to the stock of corporate borrowing.
As well as borrowing from banks, companies can raise finance by issuing equity. While the FTSE All-Share index has risen in recent years, much of that has reflected the effect of sterling's depreciation on the value of profits earned by UK-listed companies on their overseas operations. The equity prices of UK-focused companies have risen by less than the FTSE All-Share and aggregate US and euro-area indices (Chart 1.3). Reflecting that, equity risk premia — the additional return that investors require for holding equities instead of less risky government debt — are estimated to have increased for UK-focused companies in recent years.
Larger companies can also raise finance by issuing corporate bonds. Spreads on sterling corporate bonds have widened a little in recent months (Chart 1.14), reflecting some of the same factors that have driven the fall in equity prices and widening in bank funding spreads. That, combined with increases in market interest rates, means that corporate bond yields have risen over the past year, increasing financing costs for companies.
UK bank wholesale unsecured funding spreads have risen in recent months
UK banks' indicative longer-term funding spreads
Spreads on household lending rates have narrowed since mid-2016
Averages of quoted mortgage and personal loan rates(a)
Most retail interest rates have risen since August 2017 but remain lower than in mid-2016
Retail interest rates on deposits and lending(a)
Effective mortgage rates have fallen since further
Bank Rate and effective mortgage interest rates
Corporate borrowing conditions have widened slightly since February
Sterling non-financial corporate bond spreads(a)
In the MPC's central projection in the February Report, GDP was expected to grow by around 1¾% per year on average over the forecast period. While modest by historical standards, that growth rate was expected to exceed the diminished rate of supply growth of the economy, which was projected to be around 1½% per year. As a result, a small margin of excess demand was projected to emerge by early 2020 and build thereafter. That would support domestic cost growth, although CPI inflation was projected 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 remained above the 2% target in the second and third years of the MPC's central projection.
At its meeting ending on 21 March 2018, the MPC noted that recent data releases had been broadly consistent with the view of the medium-term outlook set out in the February Report. The prospects for global GDP growth remained strong, and financial conditions continued to be accommodative, with little persistent effect from the recent financial market volatility.
CPI inflation fell from 3.0% in January to 2.7% in February. Inflation was expected to ease further, although to remain above the 2% target in the short term. A range of measures of domestically generated inflation had picked up, although they generally remained below target-consistent levels. Wage growth had also increased steadily, as expected. The unemployment rate had remained low and other indicators suggested that the margin of spare capacity within the labour market was limited. Taken together with the increase in job-to-job flow rates, which could strengthen workers' bargaining power, this provided increasing confidence that growth in wages and unit labour costs would pick up to rates consistent with the inflation target.
As in February, the best collective judgement of the MPC remained that, given the prospect of excess demand, an ongoing tightening of monetary policy over the forecast period would be appropriate to return inflation sustainably to its target at a more 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.
For seven members, however, that did not require an increase in Bank Rate at this meeting. There had been few surprises in recent economic data and the February Inflation Report projections, conditioned on a gently rising path of Bank Rate, had appeared broadly on track. The May forecast round would enable the Committee to undertake a fuller assessment of the underlying momentum in the economy, the degree of slack remaining and the extent of domestic inflationary pressures.
Two members favoured a rise in Bank Rate by 25 basis points. They noted the widespread evidence that slack was largely used up and that pay growth was picking up, presenting upside risks to inflation in the medium term. A modest tightening of monetary policy at this meeting could mitigate the risks from a more sustained period of above-target inflation that might ultimately necessitate a more abrupt change in policy.
The cost of credit is an important influence on the spending decisions of households and companies. A key component of that cost is the 'credit spread' — the extent to which the interest rates facing households and companies exceed their reference rates, namely Bank Rate or longer-term equivalent market rates.
This box sets out the factors that can influence the size of the credit spread and hence the overall cost of borrowing. As shown in the stylised example in Figure A, these include the funding spread (the spread between banks' funding costs and reference rates), credit risk charges associated with the loan (which encompass both expected losses and a capital charge), other costs and a mark-up.
(i) Funding spread. Banks' funding for the loans they extend comes from a variety of sources, including wholesale funding from other lenders and institutional investors, and customer deposits. Borrowing rates on unsecured wholesale debt are a useful indicator of the marginal cost of funding for the banking system as a whole, since this is a market in which it is possible to raise a large amount of funding relatively quickly. In addition to other market influences, the funding spread will reflect the amount of compensation investors demand for the risk that a bank might fail. As explained in Section 1.3, that spread has fallen sharply since the crisis as banks have repaired their balance sheets and global risk appetite has increased.
(ii) Credit risk charges. These account for the risk that a borrower may not repay their loan in full, and are formed of two components: the expected loss associated with the loan and the capital charge. The expected loss component is determined by the likelihood that a borrower will default, together with the loss for the bank should that default occur. The capital charge component of credit risk represents the cost of capital funding — which tends to be more expensive than wholesale debt funding — in order to absorb losses in the event of a stress scenario. The amount of capital funding, and hence the cost to the bank of the capital charge, is affected by national and international regulation.
(iii) Other costs and mark-up. The remainder of the credit spread comprises additional factors, including banks' operating costs, such as staff costs and overheads, and any mark-up over and above the costs associated with making a loan. As explained in Section 1.3, strong competition between lenders means that mark-ups are likely to have fallen in recent quarters, especially in the market for mortgage lending.
Stylised example of loan pricing(a)