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The Bank of England's quarterly Inflation Report updates its key forecasts for the economy and sheds a bit more light on its thinking about when interest rates might rise and what stats will influence the timing.

First up, forecasts.

  • The most notable today will be the large downgrade to wage growth in 2014 - now expected to come in at 1.25%, down from 2.5%.
  • GDP growth expectations this year nudged up to 3.5% from 3.4% in February, but down a bit in 2015 (3.25% v 3.5%).
  • Unemployment rate to head below 6% by the end of this year and to hit 5.5% by the end of the forecast period.
  • Inflation set to remain at, or slightly below, 2% over the next two years.

Much ado about wages

Parking the Inflation Report for a moment, today's labour market data highlight one of the puzzling features of the UK's recovery - the unemployment rate continued to head south in the three months to June coming in at 6.4% - the lowest since April 2008. Total pay, on the other hand, also headed south - falling 0.2%. Some of this weakness reflected the timing of bonus payments, but even stripping these out wages grew by 0.6% - the slowest pace of increase since the series began in 2001.

Back to the Bank - their decisions on interest rates are tied to judgements on the degree of slack in the economy - how fast the economy can grow without leading to the build of inflationary pressures. The unemployment trends suggest that the economy is marching on, companies need more workers and slack is being eroded, but the pay data points in the other direction.

Taking account of the pay trends so far this year led to an inevitable downward revision to the likely outturn for wage growth for 2014 as a whole. The Bank's Report looked at some of the likely drivers of this in a bit more detail.

  • An increase in labour supply - the labour force participation rate is at its highest since 1991; women's pension age has been increased, and more older workers may be opting to stay in employment longer because of pensions concerns. (Also note - the abolition of the default retirement age may also play a part).
  • Pay increases are lagging - the unemployment rate started falling more quickly towards the end of last year, this may not have yet fed through to pay deals agreed on an annual basis. (HT to Scotiabank which also highlights a potential impact from the introduction of pensions auto-enrolment on pay negotiations).
  • The composition of employment growth - which the data suggests has been at the lower skilled and therefore lower paid end of the spectrum - influencing the pace of growth at the aggregate level.

Risks

The central forecast for GDP this year did not materially change from February, with full year growth expected to come in at 3.5%. In a slight change of time from last time, the Bank notes that risks are skewed a bit more to the downside mainly following recent international events.

  • Euro area – weak inflation could exacerbate problems with debt
  • Globally, a normalisation in US monetary policy could lead to more financial market volatility.
  • Domestically, output growth still depends on improving productivity. There is also uncertainty about how easily households and businesses can absorb the gradual rises in interest rates embodied in the market interest rate path.

Inflation

Last, but not least, what all this means for inflation. CPI inflation is projected to remain at, or slightly below, 2%, before reaching the target at the end of the two-year forecast period. Risks are seen as fairly balanced, depending on the path of wage growth, though it could also be affected by changes to international energy prices.

Clues on where next for Bank Rate?

The Bank looks set to stick to its wait and see approach. Any turnaround in productivity and wages will tip the balance of views in favour of a rate rise. Thereafter, it remains keen to stress that the most likely path is a very gradual rise in Bank Rate stopping short of historically averages.

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