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May 12, 2016 - As expected, the Bank of England's (BoE) policy decisions kept both the Bank Rate and stock of purchased
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Economic Research

12 May 2016

Bank of England Review BoE repeats it is sidelined until after the referendum As expected, the Bank of England’s (BoE) policy decisions kept both the Bank Rate and stock of purchased assets unchanged at 0.50% and GBP375bn, respectively. Both votes were unanimous (9-0). Some of the initial GBP appreciation is likely linked to some speculation about whether one member would vote for an immediate cut. As we argued after the latest BoE meeting in April, the BoE will not do anything ahead of the EU referendum as it says that the ‘[...] underlying economic momentum [is] harder to interpret at present’. Today’s focus was on references in the minutes, Inflation Report and/or press conference to the UK’s upcoming EU in/out referendum. The BoE repeated that the uncertainty related to a Brexit is weighing on the economic activity ahead of the referendum day which explains why it has lowered its expectations of Q2 growth to 0.3% q/q from 0.5% q/q. However, this may even be too optimistic given that UK PMIs across sectors are at three-year lows (see chart). It is also interesting that the BoE says that the impact may persist after vote. BoE reiterated that a Brexit ‘could materially affect the outlook for output and inflation’. In line with our view, the central bank says that higher uncertainty about UKEU trading relationships could slow consumption growth, lead to falling investments and hit the labour market through lower employment. It is also likely that GBP will depreciate, ‘perhaps sharply’. In the subsequent press conference, Carney even said that the UK probably faces a recession in the short term in case of a Brexit. Carney declined to comment on the long-term economic impact of a Brexit. The BoE also repeated the message from the April meeting that ‘whatever the outcome of the referendum, the MPC would use its tools to achieve its inflation remit’. A Brexit would present the BoE with a dilemma in terms of using monetary policy to either curb high inflation or use it to target lower growth. The BoE’s ‘Brexit reaction’ will ultimately depend on the balance of these forces. While there is some speculation that BoE could increase the Bank Rate as a response to higher inflation through a sharp GBP fall in case of a ‘Brexit’, it is also possible that the BoE might look through this due to the negative impact on demand. The BoE did the latter after the crisis when the Bank Rate was kept at 0.50% despite above-target inflation. If the BoE needs to ease monetary policy, it has several instruments to hand: It could lower the Bank Rate from 0.50% to 0.00% (currently, the BoE has ruled out negative rates), it could resume the QE programme (APF) and it could ease credit through an extension of the ‘Funding for Lending Scheme’ (FLS). Interestingly enough, Carney hinted that the BoE prefers to lower the Bank Rate before using other tools. Overall, the market reaction was limited, although we saw a slightly stronger GBP. Markets price in a 36% probability of a BoE cut before year-end 2016. We expect the first BoE hike in Q1 17 (probably in February) based on the assumption that the UK remains in the EU, but risks are skewed towards a later hike. See overleaf for Mark Carney’s chart book.

Important disclosures and certifications are contained from page 5 of this report.

As expected, the BoE kept both the Bank Rate and stock of purchased assets unchanged

Source: Bank of England

Growth has slowed ahead of the EU in/out referendum

Source: ONS, Markit Economics

Markets price in a 36% probability of a BoE cut before year-end 2016 1.00% 0.90% 0.80% 0.70% 0.60% 0.50% -0 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% May16

GBP/OIS forward market

-8

-8

-8

-7

Nov16

-7

-5

-2

May17

Current Live

-0

+11 +7 +9 +2 +4

Nov17 Policy Rate

Source: Danske Bank Markets

Senior Analyst Mikael Olai Milhøj +45 45 12 76 07 [email protected] Chief Economist, UK Angela McGowan +44 28 90 048658 [email protected]

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May18

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Carney’s chart book GDP growth has slowed ahead of the referendum GDP growth slowed in Q1 16

Private consumption grows at a solid pace

Source: ONS, Danske Bank calculations

Source: ONS, Danske Bank calculations

GDP growth vs growth in US and euro area

BoE’s GDP forecast from May may still be too optimistic in the short term

Source: ONS, Eurostat, BEA, Danske Bank calculations

Source: ONS, Bank of England

Cost pressures lower in the UK than in the US UK unit labour costs still subdued – lower than in the US

However, total ULC hides that unit wage costs are growing at the fastest rate since the crisis

Source: ONS, BEA

Source: ONS, Danske Bank

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UK an open economy – exposed to ECB’s easing bias UK twice as open as the US

UK is exposed to developments in the rest of Europe

Source: ONS, BEA

Note: Only goods exports. December value set equal to November. *EU including Norway and Switzerland ** China including Hong Kong Source: ONS

Also the labour market seems to be slowing Unemployment rate has fallen more than expected from GDP growth

4-quarter change in unemployment (pp)

Unemployment rate has declined sharply in 2015

4 3 2 1 0 -1 -2 -3

Whole sample 2014-15 Linear

-6

-4

-2

0

2

4

6

GDP growth % y/y Source: ONS

Note: Ssample is Q1 72 to Q3 15 Source: ONS, Danske Bank calculations

Still slack left – many workers are unable to find full-time jobs

Long-term unemployment still elevated

Source: ONS, Danske Bank calculations

Source: ONS

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BoE is afraid of second-round effects on wage growth Inflation expected to stay low in 2016

Solid real wage growth despite subdued wage growth as inflation is low

Source: ONS

Source: ONS, Danske Bank

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Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of the research report is Mikael Olai Milhøj, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts’ rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank’s research policies. Employees within Danske Bank’s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank’s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication.

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