Global developments and domestic financial conditions

Section 1 of the Inflation Report - May 2019
  • Global growth slowed over 2018, but appears to have stabilised in recent months. There has been a shift in the policy outlook in major economies and an associated easing in global financial conditions, which is expected to support global growth.

  • In the UK, the market path for interest rates is lower as in other advanced economies, while sterling has appreciated a little.

1.1 Global economic developments

There was a broad-based slowing in global GDP growth over 2018 across advanced and emerging market economies (Chart 1.1). UK-weighted world GDP growth appears to have stabilised in 2019 Q1, with quarterly growth expected to have increased to 0.6% (Table 1.A), higher than projected at the time of the February Report. US GDP growth picked up to 0.8% in 2019 Q1, euro-area growth rose to 0.4%, while growth in China was 1.4%.

The slowdown in global growth in part reflects a tightening in financial conditions during 2017–18, as asset prices adjusted to tighter policy, especially in the US and China. It may also reflect the imposition of trade barriers, such as tariffs on trade between the US and China, which may have contributed to weaker business confidence and a slowdown in world trade growth (Chart 1.2). In advanced economies, the slowdown in growth has been concentrated in investment and net trade (Chart 1.3).

Higher-frequency indicators suggest that UK-weighted global GDP growth will be around 0.5% in 2019 Q2. Global manufacturing and export order PMIs stabilised in 2019 Q1, having fallen over 2018, for example.

Against the backdrop of weak data, there has been a shift in the policy outlook in some major economies, with monetary policy in particular now expected to be looser than previously expected (Chart 1.4).

In the euro area, the European Central Bank (ECB) announced that policy rates are expected to remain at present levels at least until the end of 2019, longer than stated in its guidance at the time of the February Report. To help support bank lending conditions and the smooth transmission of monetary policy, the ECB also announced further two-year targeted longer-term refinancing operations, to be offered from 2019 Q3 to 2021 Q1. The market path for policy rates in the euro area slopes upwards, but gently.

In the US, the Federal Open Market Committee made no changes to its target range for the federal funds rate in March. But the path of policy rates implied by market prices has declined further over the past three months and is markedly lower than in November. It is now downward sloping, suggesting that market participants view a cut in the policy rate as more likely than an increase in coming years. The Committee also announced an end to the reduction in its balance sheet by September 2019.

In China, the authorities announced further fiscal measures to support activity, including significant cuts in taxes and increases in infrastructure expenditure. The latest fiscal measures, alongside a previous easing in monetary and credit policies, should provide support to demand.

Lower expectations for the path of policy rates have contributed to a rise in global risky asset prices, reversing weakness at the end of 2018. Equity prices internationally have risen since February (Chart 1.5) — the S&P 500 had its strongest quarter for almost 10 years for example — and corporate bond spreads have narrowed further (Chart 1.6). As a result, global financial conditions have loosened since February.

Financial market-based measures of investor uncertainty, such as the VIX measure of implied equity price volatility, have fallen back to below historical averages. Other measures of uncertainty paint a different picture, however. The Baker, Bloom and Davis index of global policy uncertainty, which includes media references to uncertainty and other indicators such as the dispersion of professional forecasts, remains elevated (Chart 1.7).

In the MPC’s central projection, the easing in global financial conditions, as well as previously announced tariff increases on US-China trade not being implemented, are expected to provide support to global growth. Four-quarter UK-weighted GDP growth is expected to trough in Q2 before recovering somewhat in 2019 H2 and settling around trend rates. The projection is a little higher than at the time of the February Report.

Chart 1.1

The slowdown in global growth has been broad-based
Four-quarter UK-weighted GDP growtha

Chart 1.1

  • Sources: Eikon from Refinitiv, IMF World Economic Outlook (WEO) and Bank calculations.

    a Constructed using data for real GDP growth rates for 180 countries weighted according to their shares in UK exports.

Table 1.A

Global GDP growth appears to have stabilised in 2019 Q1
GDP in selected countries and regionsa

Table 1.A

  • Sources: Eikon from Refinitiv, IMF WEO, National Bureau of Statistics of China, OECD, ONS and Bank calculations.

    a Real GDP measures. Figures in parentheses are shares in UK exports in 2017.
    b The 1998–2007 average for China is based on OECD estimates. Estimates for 2008 onwards are from the National Bureau of Statistics of China.
    c The earliest observation for Russia is 2003 Q2.
    d As defined in footnote a of Chart 1.1. Figure for 2019 Q1 is a Bank staff projection.

Chart 1.2

Growth of world trade in goods has slowed sharply and business confidence has fallen
OECD business confidence and world trade in goods

Chart 1.2

  • Sources: CPB Netherlands Bureau for Economic Policy Analysis, OECD and Bank calculations.

    a Three-month moving average. Volume measure.

Chart 1.3

The slowdown in advanced-economy growth has been concentrated in investment and net trade
Contributions to four-quarter GDP growth in the G7 economiesa

Chart 1.3

  • Sources: Eikon by Refinitiv, IMF WEO, OECD and Bank calculations.

    a Growth in real purchasing power parity (PPP)-weighted GDP.

Chart 1.4

Market-implied paths for interest rates have fallen markedly
International forward interest ratesa

Chart 1.4

  • Sources: Bloomberg Finance L.P. and Bank calculations.

    a The May and February 2019 and November 2018 curves are estimated using instantaneous forward overnight index swap rates in the 15 working days to 24 April 2019, 30 January 2019 and 24 October 2018 respectively.
    b Upper bound of the target range.

Table 1.B

Monitoring the MPC’s key judgements

Table 1.B

Chart 1.5

Equity prices have risen since February
Equity prices in advanced economies and emerging marketsa

Chart 1.5

  • Sources: Eikon from Refinitiv, MSCI and Bank calculations.

    a In local currency terms, except for MSCI Emerging Markets which is in US dollar terms.
    b The MSCI Inc. disclaimer of liability, which applies to the data provided, is available here.

Chart 1.6

Corporate bond spreads have narrowed
International non-financial corporate bond spreadsa

Chart 1.6

  • Sources: Eikon from Refinitiv, ICE/BoAML Global Research and Bank calculations.

    a Option-adjusted spreads on government bond yields. Investment-grade corporate bond yields are calculated using an index of bonds with a rating of BBB3 or above. High-yield corporate bond yields are calculated using aggregate indices of bonds rated lower than BBB3. Due to monthly index rebalancing, movements in yields at the end of each month might reflect changes in the population of securities within the indices.

Chart 1.7

Global policy uncertainty remains elevated
Global policy uncertainty and implied volatility of US equity prices

Chart 1.7

  • Sources: Bloomberg Finance L.P., and Bank calculations.

    a VIX measure of 30-day implied volatility of the S&P 500 equity index. Monthly averages.
    b See Baker, S R, Bloom, N and Davis, S J (2016), ‘Measuring economic policy uncertainty’, The Quarterly Journal of Economics.

1.2 Domestic financial conditions

As in other countries, UK short and longer-term interest rates have fallen and equity prices have risen since February. Credit conditions facing corporates have loosened a little as corporate bond spreads have narrowed, while those facing households have remained generally favourable. Sterling has appreciated a little.

Market interest rates and sterling

The market-implied path of Bank Rate over the next three years is, on average, around 15 basis points lower than in February, and is now expected to reach around 1.0% in three years’ time (Chart 1.4). Longer-term UK interest rates are also lower: the yield on 10-year UK government bonds has declined to 1.2% from 1.3%. Combined with the moves in the run-up to the February Report, both short and long-term interest rates have fallen by around 40 basis points since November.

The sterling ERI has been sensitive to Brexit developments. It has appreciated by 1½% since the February Report, which market contacts attribute to a lower probability being attached to a no-deal Brexit. The sterling ERI remains around 15% below its November 2015 peak (Chart 1.8).

Following the extension to the negotiation period for the UK’s withdrawal from the EU, sterling implied volatilities — an indicator of uncertainty around the outlook for the exchange rate — fell sharply. And the cost of insuring against a large depreciation relative to a large appreciation also fell, as market participants appear to be pricing in a lower probability of a sharp fall in sterling over the next six months.

Credit conditions facing companies and households

Over the past few years, credit conditions facing companies have been relatively accommodative. However, conditions in corporate bond markets — which large companies use to borrow — deteriorated at the end of 2018. Bond spreads across the main markets in which UK companies borrow widened markedly (Chart 1.6). These spreads have since narrowed, driven by the same factors that eased financial conditions globally (Section 1.1). UK corporate bond issuance has resumed, although it remained below its historical average in 2019 Q1 with most issuance concentrated among investment-grade companies.

According to the Credit Conditions Survey, the availability of bank credit to companies has been little changed in recent quarters. However, reports from the Bank’s Agents suggest that the availability of credit has tightened for sectors that may be more exposed to Brexit, such as export-focused firms.

The Credit Conditions Survey indicates that the demand for corporate credit has remained subdued. Respondents to the Survey did, however, report an increase in the demand for inventory finance in Q1 and almost two thirds of respondents to the Lloyds Business Barometer survey in March reported that they were prepared for Brexit-related pressures on working capital. Supervisory intelligence suggests that, as yet, the banks accounting for the majority of lending to corporates have not reduced their willingness to provide working capital finance. The majority of respondents to the Agents’ recent survey also reported no change in the availability and cost of working capital or trade finance in the past three months (Box 5).

Credit conditions facing households have generally remained favourable. Mortgage rates have been stable at low levels, despite large moves in spreads on banks’ unsecured wholesale debt over the past six months. Box 2 discusses recent developments in mortgage rates.

There is some evidence of a tightening in household credit conditions in parts of the unsecured lending market. While personal loan rates remain low (Table 1.C), respondents to the Credit Conditions Survey reported that the availability of unsecured credit tightened further in 2019 Q1. In the credit card market, interest-free periods on purchases and balance transfers have continued to fall; the maximum 0% balance transfer period has fallen to below 30 months for the first time since 2013. That tightening in credit supply is likely to have accounted for some of the slowing in consumer credit growth over 2018.

Chart 1.8

Sterling has risen a little since February
Sterling ERI

Chart 1.8

Table 1.C

Retail interest rates remain low
Selected household quoted ratesa

Table 1.C

  • a The Bank’s quoted rate series are weighted monthly average rates advertised by all UK banks and building societies with products meeting the specific criteria. Not seasonally adjusted. Data for April are flash estimates and subject to change until they are published on 8 May. Since February 2019 data, the methodology used to calculate these data has changed; for more information see here.

Box 1 Monetary policy since the February Report

At its meeting ending on 21 March 2019, the MPC noted that the news in economic data had been mixed, but that the February Report projections appeared on track. In those projections, a weaker near-term outlook was expected to lead to a small margin of slack opening up this year. Thereafter, demand growth exceeded the subdued pace of supply growth and excess demand built over the second half of the forecast period.

The broad-based softening in global GDP and trade growth had continued. Global financial conditions had eased, in part supported by announcements of more accommodative policies in some major economies.

Shifting expectations about the potential nature and timing of the UK’s withdrawal from the EU had continued to generate volatility in UK asset prices, particularly the sterling exchange rate. Brexit uncertainties had also continued to weigh on confidence and short-term economic activity, notably business investment. Employment growth had been strong, although survey indicators suggested that the outlook had softened. Most indicators of consumer spending were consistent with ongoing modest growth. As the Committee had previously noted, short-term economic data might provide less of a signal than usual about the medium-term growth outlook.

CPI inflation had risen slightly to 1.9% in February and was expected to remain close to the 2% target over coming months. The labour market had remained tight and annual pay growth, having risen through 2018, had remained around 3½%. Given continuing weakness in productivity growth, growth in unit wage costs had also risen, although other indicators of domestically generated inflation had remained modest.

The Committee’s February Report projections were conditioned on a smooth adjustment to the average of a range of possible outcomes for the UK’s eventual trading relationship with the EU. The MPC noted that the economic outlook would continue to depend significantly on the nature and timing of EU withdrawal, in particular: the new trading arrangements between the EU and the United Kingdom; whether the transition to them is abrupt or smooth; and how households, businesses and financial markets respond. The appropriate path of monetary policy would depend on the balance of these effects on demand, supply and the exchange rate. The monetary policy response to Brexit, whatever form it takes, would not be automatic and could be in either direction.

As in February, the MPC judged that the current stance of monetary policy remained appropriate. The Committee continued to judge that, were the economy to develop broadly in line with its February Report projections, an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate to return inflation sustainably to the 2% target at a conventional horizon.

Box 2 Recent developments in new mortgage rates

Over the period since the financial crisis, the average interest rate on new mortgages has fallen markedly reaching a low of just under 2% in October 2017. Since then, Bank Rate has risen by 50 basis points but the average rate on new mortgages has increased by less (Chart A). As a result, the difference between new mortgage rates and risk-free rates — the mortgage spread — has fallen further.

One factor that is likely to have weighed on new mortgage rates, potentially offsetting the upward impetus from Bank Rate, is competition in the mortgage market. Discussions with lenders suggest that competition has been intense for some time. Since the start of 2018 this is most apparent in the high loan to value (LTV) segment of the mortgage market: the average quoted rate on two-year fixed 95% LTV mortgages has fallen by around 80 basis points despite reference rates having picked up slightly (Chart B).

Competition in the mortgage market may have been amplified by the ring-fencing of major UK banks which separates retail banking services from other activities.1 As some ring-fenced entities have more domestic deposits than loans, and are subject to restrictions on the type of banking activity they can undertake, they may be incentivised to increase mortgage lending.

Lending rates will also be affected by developments in banks’ funding costs. While the cost of bank funding raised in wholesale markets has fluctuated substantially in recent months, those movements have not been transmitted to mortgage rates. As discussed in Box 1 of the February Report, the importance of wholesale unsecured funding spreads in loan pricing is likely to have fallen as the large retail banks increased their share of deposit funding, particularly sight deposits, relative to wholesale funding. Indeed, the value of banks’ deposits now exceeds that of their loans, and supervisory intelligence indicates that banks take into account deposit rates when pricing loans.

Given those developments, the stability of deposit rates over the past few years (Chart A) may help explain the stability of mortgage rates. Prior to 2008, sight deposit rates were some way below Bank Rate. When Bank Rate was cut to very low levels during the financial crisis, deposit rates fell by less and the spread between them became positive. Retail banks’ desire to return this spread towards more normal levels may help explain why deposit rates, and therefore mortgage rates, have not risen one-for-one with Bank Rate recently.2

In the MPC’s projection, mortgage rates are expected to pick up gradually over the forecast period partly because spreads on new mortgage lending over risk-free rates widen a little. There is uncertainty around that judgement, however, as it will depend on how factors such as competitive pressures and deposit rates evolve. The MPC will continue to monitor the dynamics in the mortgage market, as well as its implications for the monetary transmission mechanism more broadly.

Chart A

The average interest rate on new mortgages has risen by less than Bank Rate recently
Bank Rate and household effective interest rates

Chart A

  • a The Bank’s effective rate series are weighted averages of rates from a sample of banks and building societies with products meeting the specific criteria. Not seasonally adjusted.
    b End-month rate.

Chart B

High LTV mortgage rates have fallen recently, despite reference rates having picked up
Average quoted rates on two-year mortgages and two-year OIS ratea

Chart B

  • a The Bank’s quoted rate series are weighted monthly average rates advertised by all UK banks and building societies with products meeting the specific criteria. Not seasonally adjusted.
    b Monthly averages of two year ahead sterling overnight index swap (OIS) rates.
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