While keeping UK interest rates on hold, the Bank of England (BoE) sent a strong message on Thursday for investors to expect more rate tightening in the not-too-distant future.
An accelerating global growth backdrop means the UK economic outlook is still much better than many had feared.
However, it's by no means all good news on the economic front as part of the BoE´s justification for a more hawkish outlook is that the UK economy is less able to grow without stoking inflation than it was in the pre-crisis years.
The BoE´s Monetary Policy Committee unanimously voted at its February meeting to keep interest rates unchanged at 0.5%.
But it was the BoE´s emphatic warning that UK interest rates would likely need to be “tightened somewhat earlier and by a somewhat greater extent” that caught investors' attention.
The pound immediately jumped against the dollar after the minutes of the February meeting were released.
UK government bond yields also rose sharply as investors priced in higher interest rate expectations.
“We now expect the BoE to increase rates at the May meeting. And given the Bank’s suggestion that rates will need to rise by a “greater extent”, a second hike in November certainly can’t be ruled out,” said James Smith, an economist at ING.
The reason economists were a little surprised by the BoE´s statement on Thursday was that the UK´s major economic ill of 2017, namely accelerating inflation, has been tipped to subside in 2018.
Indeed, while still well ahead of the BoE´s 2% target, UK inflation eased to 3% in December compared to 3.1% in the prior month.
And, as the BoE points out in its statement today: “Sustained above-target inflation remains almost entirely due to the effects of higher import prices following sterling’s past depreciation.”
In other words, it was the post-Brexit depreciation of sterling that saw inflation shoot up over the course of 2017.
Currency depreciation tends to have a delayed, albeit potent effect on domestic price levels. The sharp depreciation in the pound following the Brexit vote in 2016 took some time to work its way through.
The point is though that sterling has been relatively stable for some time. Thus far in 2018, it has actually been appreciating against most major currencies. So, shouldn´t this help the UK to meet the BoE´s inflation target anyway?
It certainly should, but for now the BoE appears to believe this will not be enough by itself.
“These external forces slowly dissipate over the forecast, while domestic inflationary pressures are expected to rise,” says the BoE, as it points to steadily rising wages against a tighter labour market.
“On balance, CPI inflation is projected to fall back gradually over the forecast but remain above the 2% target in the second and third years of the MPC’s central projection,” explains the BoE.
Nevertheless, it’s still by no means a foregone conclusion that the MPC will actually vote in favour of a rate hike in May, or even during 2018 at all.
Developments on the Brexit front, and the UK´s domestic political environment, which is currently all but completely dominated by the former, present a great deal of economic uncertainty.
One of the reasons for sterling´s positive performance so far in 2018, having gained 3% against the dollar, and just over 1% versus a strong euro, is the decision by EU leaders to allow Brexit talks to progress to trade matters.
This was seen as making a cliff-edge Brexit, with the UK leaving the EU without an agreement, appear less likely.
More recently, however, reports suggest the UK cabinet is more divided than ever over what kind of Brexit it actually wants.
Tellingly, a Reuters poll published on Thursday showed that forecasters generally believe Brexit concerns will soon start to hold sterling back.
At one stage on Thursday, in the aftermath of the BoE´s statement, the pound was up by over 1% against the dollar. However, by 1730 GMT, the pound had shed most of its earlier gains, and was trading just 0.3% up against the dollar on the session.
“All told, then, the MPC has signalled to markets that a May rate hike is under active consideration, but is far from guaranteed. With the economy still lacking real momentum, Brexit talks likely to progress slowly and the housing market showing significant signs of stress, we still think that the MPC will hold back until August,” says Sam Tombs, chief UK economist at Pantheon Macroeconomics.