ECB View: Rehn more explicit on rate hike timing – Olli Rehn, ECB Governing Council member and Governor of the central bank of Finland, made perhaps the most explicit comment yet on the timing of the first ECB rate hike. Mr Rehn noted earlier today that ‘the starting point should be that if the economy develops roughly in line with the current outlook, the first rate increases would take place in the final quarter of 2019’. The official line from the Governing Council is that it expects the policy rates to ‘remain at their present levels at least through the summer of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term’. The Governing Council member went on to say that ‘markets appear to be reading the ECB’s forward guidance correctly’. In our view, markets are priced somewhat more aggressively than the Q4 guidance. A 10bp rate hike is priced in for September, with almost 20bp priced in by the end of the year. We assume that 10bp steps are likely, given the ECB’s assertions that the exit process will be cautious and prudent. Our base case is that the ECB will raise its deposit rate by 10bp in December of next year, taking it to -0.3%. The risks are skewed towards later. We think that core inflation will undershoot ECB forecasts against the background of slack in the eurozone labour market as a whole and relatively moderate economic growth. In addition, the risks to the economic outlook are to the downside. Finally, by the end of next year, Fed rate hikes will be behind us and US economic growth will be slowing. The ECB may then be in a position to deal with significant euro strength if it were to move too quickly. We therefore think financial markets are too aggressive in their current pricing. (Nick Kounis)
UK Macro: Stagflation likely if Brexit is disorderly – As crunch time in the Brexit talks approaches, with the prospect of a deal still highly uncertain, investor attention is inevitably turning to what could occur if the UK were to crash out of the EU without a deal next March. While it is difficult to forecast with precision what the macro effects would be of such a chaotic outcome, stagflation – a combination of low (or negative) growth and high inflation – would be the most likely result. The sudden imposition of tariffs and customs checks at the border would bring potentially widespread disruption to the UK economy, lead to falls in investment, and dampen consumer and business confidence. The combined effects of these would likely lead to a technical recession in the first half of 2019, with only a shallow recovery thereafter. All told, we would expect annual growth of 0.1% in 2019, compared to 1.7% in an orderly Brexit scenario. Inflation meanwhile would be boosted by a renewed fall in sterling, which would more than offset the effects of weaker demand, and this would squeeze real incomes just as wage growth is starting to pickup.
What would the Bank of England do, faced with such a scenario? According to media reports, Governor Mark Carney has warned the government that the monetary policy response would not be as clear-cut as in the referendum aftermath, given that supply would be hit by new trade barriers, as well as demand. We still think the MPC’s bias would be for further easing, but that policy would probably stay on hold barring a very negative and sustained demand shock. For more on the potential macro outcomes of each Brexit scenario, see our UK Watch: The macro impact of Brexit scenarios. (Bill Diviney)