Economics and Banking – Page 398 – Digital Finance Analytics (DFA) Blog

Westpac Turns The Property Investment Lending Tap On

Westpac has lifted the maximum LVR for investment loans to 90%, up from 80% (which was below many other lenders). With the largest share of investment loans they trimmed back their lending to the sector last year in order to get under the regulators 10% speed limit. Now the brakes are off, and with refinance growth slowing, and loans to overseas investors on the nose, lenders are targetting the investment sector. Other underwriting parameters are still tighter than they were.

The Digital Finance Analytics household survey highlighted that demand from investors was on the rise, and last month there was more growth in investment loans, as investors gained renewed confidence in home price growth, and saw the prospect of negative gearing changes dissipate. The RBA’s rate cut was the gilt on the gingerbread.

Given that household lending appears to be the only game in town to force economic growth, it will be interesting to see how the RBA and APRA react to a resurgence in the more risky investment lending sector. They seem happy with a 7% annual growth in credit, a rate way higher than real incomes or inflation, meaning high household debt will go higher still.

Re-Proposed and Strengthened Pay Rules for US Banks

From Moody’s

Last Monday, six US federal regulators1 proposed rules to prohibit financial institutions from offering incentive-based compensation that could encourage excessive risk-taking by senior executive officers and other so-called significant risk takers. The rules, mandated by the Dodd Frank Act, will apply to a broader range of employees than the regulators’ 2011 joint proposal, which was never implemented. The new proposal introduces more stringent requirements for incentive compensation deferral and compensation recoupment (i.e., clawback).

The rule would apply to banks, asset managers, broker-dealers and other financial institutions with total consolidated assets of more than $1 billion. Larger institutions would have more stringent requirements in the new tiered approach, which classifies institutions into Level 1, those with $250 billion or more in assets, which would have the most stringent standards; Level 2 institutions with $50-$250 billion would have less stringent standards; and Level 3 institutions with $1-$50 billion (Level 3) would have easier requirements.

The revised rules apply to a larger swath of employees than the 2011 proposal. For example, the definition of “senior executive officers” has been expanded to cover roles including chief compliance officer, chief credit officer and the heads of control functions. The definition of “significant risk takers” such as loan officers and underwriters would also include employees who receive at least one-third of their pay from incentive compensation (excluding senior executive officers) and meet certain compensation tests, such as being among the top 5% of highest-compensated employees.

At Level 1 banks, the largest banks, senior executives would be required to defer at least 60% and other key risk takers at least 50% of their annual incentive compensation for at least four years. At Level 2 institutions, senior executives would defer 50% and other key risk takers 40%, for at least three years. Most large banks that require deferrals defer at least half of senior executives’ incentive compensation for three years, but few use a four-year period. During the deferral period, the awards would be subject to reduction and forfeiture in various adverse outcomes, including poor financial performance. Reducing compensation before it has vested is easier than clawing it backing it after it has been paid out.

To cover compensation that has already been paid out, tough clawback policies apply to 100% of incentive-based compensation for up to seven years after the awards have vested in cases of misconduct, including fraud, intentional misrepresentation of information used to determine the individual’s bonus compensation, and misconduct that resulted in significant financial or reputational harm to the bank. Most banks already have clawback polices in place, but clawback periods rarely extend beyond three years, and then only at the largest banks.

Most aspects of the proposal are credit positive, but the mandatory deferral and vesting periods may be too short to cover risks that only become apparent over say seven to ten years, as with fines and litigation.

Other jurisdictions, including the UK and Switzerland, require longer minimum deferral, vesting, and clawback periods, which we view favorably.

Because the proposal is largely consistent with current practice and interagency guidance, we expect larger banks will have little difficulty implementing the rules, with the possible exception of strengthening clawback polices and expanding the scope of covered employees. Smaller banks may face more difficulty adapting to the changes since their compensation practices vary more widely.

Was The Last RBA Rate Cut Needed?

From Business Insider.

The intervention of former RBA governors continues.

Recently Bernie Fraser said he is not “in the slightest” bit worried about letting inflation in Australia slip below the bottom of RBA’s 2-3% band.

His comments have now been reiterated by Ian Macfarlane, the man who followed him as governor of the Reserve Bank.

The AFR reports this morning that Macfarlane, who is now a director of the ANZ bank, took dead aim at market traders and forecasters whom he implies don’t understand the RBA’s approach to inflation targeting.

He said the problem at the Reserve Bank “is that financial markets, particularly offshore, assume a mechanical application of what they regard as the standard model”.

That’s a comment that reflects the reality of how the RBA has conducted monetary policy since the inflation targeting approach was first adopted under Fraser’s reign at the bank.

“The RBA has always prided itself on having a more flexible – as opposed to mechanical – inflation targeting model than other countries,” Macfarlane said.

He’s right on the money. The flexibility the RBA has given itself in the management of monetary policy, and its approach to the wild gyrations of the Australian dollar, are in no small part responsible for Australia’s magic run of 25 years without a recession.

But Macfarlane also appears to have a message to those who believe the RBA will have to cut deeply in the future (my emphasis).

The inflation targeting approach says that if inflation forecasts are below target, we should run an easy monetary policy – we already have that. It doesn’t say that each time we receive an inflation statistic showing it is below target, we have to cut interest rates.

You can read the original story at the AFR here.

Global Low Rates For Longer

What is driving long-term interest rates lower around the world lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years. The ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

BoE-Rates In a speech to the London Business School, external Bank of England MPC member Gertjan Vlieghe, explores the reasons for low long-term interest rates. “Long-term interest rates play an important role in monetary policy.

They are a key part of the transmission mechanism, via which monetary policy affects the wider economy.

And they contain useful information about expected future policy rates and expected future inflation.”

Jan also reflects on the current UK outlook. He says that the EU referendum has caused increased uncertainty and poses challenges for the MPC in assessing how much of the continued slowdown in GDP growth “is due to the referendum, an effect which should be short-lived, and how much of it reflects a more fundamental loss of underlying momentum, which might be more persistent”. Given this, following the referendum he “would like to see convincing evidence of an improvement in the economic outlook, in line with the forecasts in the May Inflation Report. If such improvement is not apparent soon, this will reduce my confidence that inflation is likely to return to the target within an acceptable time horizon without additional monetary stimulus.”

In the UK, long-term interest rates have been coming down gradually since the early 1980s and the current 10 year bond yield is now about 1.5%.

Jan decomposes long-term interest rates into real and nominal components as well as expectations and risk premia components. He finds that “the most important factor behind the fall in long-term interest rates since the financial crisis has been a downward revision in the expected path of policy rates, with inflation expectations relatively stable, thus reflecting lower expected future real rates”.

This analysis suggests that “the reason expected future real rates are low is that monetary policy has responded, and is expected to continue to respond, appropriately to persistent forces weighing on demand and inflation”.

The analysis also suggests asset purchases have not “distorted” government bond yields. Instead, the main effect of asset purchases on long-term interest rates appears to have been due to the signal sent by purchases about the Bank’s reaction function and thereby led to a downward revision of the expected future path of interest rates. This finding also “sheds light on the likely impact of unwinding asset purchases”.

Finally, Jan applies the same decomposition to a range of countries with varying monetary policies all of which show “a substantial fall in the expected path of future interest rates” with the path of future policy rates “revised down by several percentage points on average.” This suggests that “what is driving long-term interest rates lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years”.

This supports Jan’s argument in his speech in January that ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

RBNZ Does Digital Banking Disruption

An article published today in the NZ Reserve Bank Bulletin explores the potential effects of digital disruption to banks and broader financial system stability. Consumers now expect the same seamless digital services from banks as they receive from other industries. Hence, the banking industry is being ‘digitally disrupted’ as banks and technology firms race to meet this expectation.

This article explores whether the digital disruption of banking is a ‘disruption’ or more of a ‘distraction’ and aims to understand the concept of digital disruption of banking, what is driving it, what are the impacts on banks, and what are the impacts on financial system stability. It finds that the disruption is occurring in all areas of banking but particularly in retail customer interactions.

Banks using new technologies to improve their services is not a new phenomenon. Over the late 1980s to 1990s automated teller machines (ATMs), electronic debit and credit cards, and telephone banking started replacing paper-based payments. Then, through 2000 to 2010, basic banking products became digitally available through the introduction of remote access to bank accounts via mobile banking and internet banking. However, these earlier digital trends were predominantly driven by the supply side (i.e. by banks themselves) to improve the cost efficiency of supplying banking services, and therefore improve profitability.

This current wave of digitisation is different to earlier periods of innovation in the banking industry in that it is primarily driven by consumers rather than banks. Consumers now expect more accessible, convenient and smarter transactions (using internet and mobile devices) when accessing and managing their finances, as they have experienced this convenience in other activities such as shopping and transportation. Advances in new technologies and the changing customer expectations have enabled non-bank firms, such as large technology companies (for example Amazon, Facebook and Google) and start-ups (for example PushPay, Moven and Harmoney), to provide innovative bank-like services and take a share of the banking industry profits. These firms can be referred to as ‘disruptors’.

The emergence of disruptors poses a threat to the traditional banking model and is referred to as the disruption of the banking industry. A survey by Efma and Infosys Finacle (2015) revealed that 45 percent of banks viewed global technology companies as high threat and 41 percent of banks also viewed start-up companies as high threat. Under the current model of retail banking most services are provided by banks. However, after the digital disruption of banking, ‘front-end’ (or ‘customerfacing’) banking services such as the sales and distribution of banking products, account management and payment instructions may also be provided by disruptors. However, disruptors do not appear to be engaging in ‘back-end’ services such as holding deposits and settling payments because these activities tend to be captured by prudential regulation which makes them more expensive to provide due to additional compliance costs.

‘Millennials’ (the generation born 1981–2000) appear to be driving this ‘disruption’ of banking services. A three-year survey of views of 10,000 Millennials in the United States reported that the banking industry was the industry with the highest risk of disruption due to the Millennials’ low loyalty towards banks and expectations that technology companies could service their banking needs better. The survey found that:

71 percent of respondents would rather go to the dentist than hear from their bank,
one in three respondents was open to switching banks,
nearly half of the survey participants were counting on the change to traditional banking models to come from technology start-ups; and
73 percent of respondents indicated they would be more excited about a new financial product offering from Google, Amazon, Apple, PayPal or Square than from their bank.

Banks’ core roles are to act as an intermediary between depositors and borrowers, help manage risks for depositors and lenders, and provide payment services. In fulfilling these roles the banks provide security and convenience to the depositors and access to credit for borrowers. Banks are also key agents in the creation of money (via fractional reserve banking), distribution of notes and coins, and are part of the transmission of monetary policy (via the rates charged for loans and paid on deposits). A central question is if and how this ‘digital disruption’ described in the previous section will affect the bank’s core roles or whether this disruption is limited to the banks’ retail distribution models and interactions with consumers. It appears that digital disruption will impact both the retail distribution and customer interaction models of banks, as well as potentially disrupting the core role of banks.

A survey by McKinsey&Company of the customer segments and products of 350 globally leading financial technology firms (or leading ‘disruptors’) revealed that all banking segments are at risk of disruption. However, the main area of concentration of these disruptors is the retail sector, and the various products and services tied to payments, lending and financing.

A key potential effect of digital disruption on banks in the short to medium term is the loss of profitable activities and services.

In the long term, banks’ role in the financial system may be challenged. Disruptors may become systemically important if they supply a large portion of front-end banking services. For example, if peer-to-peer or equity lending platforms grow rapidly then it is possible that a significant number of credit decisions could be made by lending platforms. Likewise it is possible a significant number of payments may be initiated using mobile wallets.

If banks lose profits generated at the front-end of banking services they may become less resilient in an economic downturn. Stress test results reveal that the profitability of New Zealand banks provides a buffer against losses in downturn scenarios where a large number of creditors default on their loans. Lower profitability results in a smaller buffer against potential losses caused by an economic downturn, and also reduces access to international capital markets as the cost of funds increases in proportion to the riskiness of the bank.

In a more hypothetical long term scenario, banks may be challenged to change the fundamental model of banking in order to meet the demands of Millennials as they progress through life. As described above, digital disruptors are more likely to have a stronger relationship with younger customers (or Millennials) which could pose a considerable threat to the business models of incumbent banks.

In the short to medium term, digital disruption may result in new risks and increased instability in the financial system. For example, peer-to-peer lenders do not take on credit risk in the same manner as a bank, they do undertake decisions on behalf of lenders and so may introduce different operational risks to the borrowing and lending process. Likewise, payments innovations may introduce new operational risks to the payments system.

Further, as banks undertake core banking system redevelopment projects this may increase project risks to the banking system. Large technology projects commonly run over time and over budget and if these projects are not managed appropriately they could result in significant disruptions to customer services and bank profitability.

In the medium to long term, digital disruption of the banking sector may improve the efficiency of the financial system. For example, new payments providers increase the speed and ease of initiating payments for consumers, and the application of new technologies (such as ‘blockchain’) could increase the speed and reduce the cost of making cross-border payments. In addition, P2P platforms reduce the cost of matching borrowers with lenders as there are no physical branches to maintain.

The long term impact of digital disruption on financial system soundness is less clear. Soundness may be reduced if existing banks’ profitability buffers are reduced due to increased competition from digital disruptors. However, digital disruption may also improve financial system soundness if it results in more competitors entering the banking sector and fewer systemically important banking entities. This may reduce the impact of a single entity failure. Further, this may alleviate the ‘too-big-to-fail’ risk where authorities may feel pressured to prevent large banks from failing due to systemic concerns. This would in turn, reduce the probability of banking entities taking on risks that they are not willing to bear (moral hazard).

The introduction of new ‘digital’ competitors is driving banks to respond with digital strategies including the modernisation of their core banking systems. Digital disruption may impact financial stability both positively and negatively, and the Reserve Bank continues to monitor it closely.

RBA Minutes Show Lower Reported Inflation Tipped The Cut … Just

The RBA Board minutes, released today suggests that, inflation outlook apart, things are set fair … so, given the low rate already, why cut at all? Have they been captured by central bank group think? After all, ultra low/negative rates are working so well in er… well, not Japan, Europe, UK or USA… Chances are going lower will just make the journey back to more normal times more painful and longer.

In considering the stance of monetary policy, members noted that the recent data on inflation and labour costs had been lower than expected at the time of the February Statement on Monetary Policy. Although the March quarter outcome for the CPI reflected some temporary factors, the broad-based softness in prices and labour costs signalled less momentum in domestic inflationary pressures than had previously been expected. As a result, there had been a downward revision to the inflation outlook and the profile for wage growth. Underlying inflation was expected to remain around 1–2 per cent over 2016 and to pick up to 1½–2½ per cent by mid 2018.

The recent data suggested that growth in Australia’s major trading partners was likely to be a little softer than previously expected and below its decade average in 2016 and 2017. While growth in the Chinese economy had continued to slow, the growth outlook had remained much as previously forecast based on the expectation of further support being provided by more stimulatory policy settings. The renewed focus of the Chinese authorities on the short-term growth targets had been accompanied by a strong rally in bulk commodity prices over recent months. Higher commodity prices would typically support incomes and activity in Australia. However, the rally in commodity prices was not expected to boost mining investment over the next couple of years.

Sentiment in financial markets had improved following a period of heightened volatility earlier in the year. Despite uncertainty about the global economic outlook and policy settings among the major jurisdictions, funding costs for high-quality borrowers remained very low and, globally, monetary policy was remarkably accommodative.

Domestically, the outlook for economic activity and unemployment had been little changed from that presented three months earlier. The available data suggested that the economy had continued to rebalance following the mining investment boom, supported by very accommodative monetary policy and the depreciation of the exchange rate since early 2013, which had helped the traded sector. GDP growth overall had been a bit stronger than expected over 2015, but appeared to have been sustained at a more moderate pace since then. Growth was forecast to pick up gradually to be above estimates of potential growth later in the forecast period. Accordingly, the unemployment rate was expected to remain around current levels for a time before declining gradually as GDP growth picked up. The exchange rate depreciation since early 2013 was assisting with growth and the economic adjustment process, although an appreciating exchange rate could complicate this.

In coming to their policy decision, members noted that developments over recent months had not led to a material change in the outlook for economic activity or the unemployment rate, but the outlook for inflation had been revised lower. At the same time, they took careful note of developments in the housing market, which indicated that supervisory measures were strengthening lending standards and that the potential risks of lowering interest rates therefore were less than they had been a year earlier.

Members discussed the merits of adjusting policy at this meeting or awaiting further information before acting. On balance, members were persuaded that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting.

The Decision

The Board decided to lower the cash rate by 25 basis points to 1.75 per cent, effective 4 May.

Why the Reserve Bank should resist calls to alter its inflation range

From The Conversation.

For economists and others who ‘grew up’ being challenged to achieve low and stable inflation against the background of high and volatile inflation rates that emerged in Western countries in the 1970s (and persisted in Australia through the 1980s), the possibility inflation could be ‘too low’ can seem like something from another universe.

The Reserve Bank of Australia’s 2-3% inflation target was more-or-less unilaterally promulgated by Bernie Fraser (who was RBA Governor from 1989 until 2006).

In a speech just after the 1993 election (at which the Liberal Opposition had advocated the introduction of a 0-2% inflation target, similar to that which had been adopted in New Zealand in 1989), Fraser suggested that:

“If the rate of inflation in underlying terms could be held to an average of 2-3% over a period of years, that would be a good outcome. Such a rate would be unlikely to materially affect business and consumer decisions, and it would avoid the unnecessary costs entailed in pursuing a lower rate.”

Although Bernie Fraser was initially “rather wary of inflation targets”, he explicitly couched the series of interest rate hikes he implemented during the second half of 1994 as being undertaken in order to maintain inflation within the 2-3% range.

The target was formally embodied in a Statement on the Conduct of Monetary Policy agreed between newly-installed Treasurer Peter Costello and newly-appointed RBA Governor Ian Macfarlane shortly after the 1996 election, and has been re-iterated after each change of government and upon each appointment of a new RBA Governor ever since.

Australia’s approach to inflation targeting differs from that of most other countries which have inflation targets in two important respects. First, it does not stem from a government directive, nor is it enshrined in legislation. As former Governor Ian Macfarlane has said, “the government didn’t introduce it, we introduced it”.

The Reserve Bank does not have to “explain itself” to politicians if it “misses” its target for some reason. Second, the target is intentionally and explicitly flexible. It is expressed as a range, to be achieved “on average” and “over the course of the business cycle” (a term which is not anywhere defined), rather than at all times and in all places, as it were.

This means that the Reserve Bank can “tolerate” inflation being either above or below the target for a temporary period if it has good reason to believe that the deviation is only temporary, or is the result of some one-off factor whose influence will soon pass, without needing to take monetary policy actions to push it back into the target range more quickly but which would, in the RBA’s judgement, not otherwise be necessary.

This “flexible inflation targeting regime” has served Australia well over the past two-and-a-bit decades. The target is widely perceived to be “credible” – that is, it is widely recognised and understood that the Reserve Bank will do what it needs to do in order to ensure that it is achieved (as it demonstrated, for example, in 1994 and in 2007).

As a result, it has served to “anchor” inflationary expectations – that is, to give participants in the economy (businesses, consumers, union officials, governments and others) a sound basis for expecting that inflation will average somewhere between 2 and 3% over the medium-to-longer term – as it was intended to do.

And it has allowed the RBA to keep interest rates more stable than would have been the case if it had been required to chase after inflation on each and every occasion on which it temporarily departed from the target range.

With the annual “headline” rate of inflation having been below the bottom end of the 2-3% target range since the December quarter of 2014, and more recently the annual “underlying” inflation rate also having dropped below 2%, some have suggested that the inflation target should itself be lowered.

This would allow the central bank more room to accommodate unusually low inflation without having to cut rates to levels which might risk triggering unsustainable rates of credit growth and/or an asset price bubble.

Ironically, the opposite proposition was put during the resources boom of 2010-12, when some suggested that the RBA should increase its inflation target so as not to have to raise interest rates as much in the face of the inflationary pressures which it was feared that boom might engender.

The RBA resisted such calls on that occasion, and should do so on this. As it is formulated, the RBA’s flexible inflation target gives it latitude to determine how dogmatic it needs to be in pursuit of “low and stable” inflation.

If it were to change its target every time it appeared as though inflation might be either above or below the target range for an extended period, the target would eventually lose whatever role it has as an “anchor” for inflation expectations, increasing the chance that inflation would – as a result of the well-documented propensity of inflation expectations to become self-fulfilling – remain above or below the target for even longer, and perhaps by even wider margins.

Australia’s inflation targeting regime has served the country well, and the challenges it faces at this time are not so great as to warrant altering it.

Author: Saul Eslake, Vice-Chancellor’s Fellow, University of Tasmania

Housing Lending Keeps The Ship Afloat

The final data from the ABS for March lending finance includes data on all the flows, including commercial. Trend finance for owner occupied housing flows fell 0.7% to $20.9 billion in the month, personal finance rose 0.5% to $6.9 billion and commercial finance fell 1% to $41.9 billion (which includes investment housing lending of $11.7 billion).

Looking at the overall lending trends, we see on a 3 month rolling average, credit flows fell by 0.73% and have been falling since October 2015.

Data on commercial lending for the purchase of existing investment properties shows an uptick, based on the original data by selected states. After the slowing around the summer, it is now trending higher, especially in NSW (before the cash rate cut).

We can also look at some of the other ratios which are important. First, total housing lending – including owner occupation and investment made up 46.7% of all lending flows. This is a record, and shows that the banks are reliant on housing lending to keep their ships afloat. The proportion of commercial lending not investment property related to all lending was 42.7%, and has been falling since October 2015. The proportion of commercial lending which was for investment property related, to all commercial lending rose to 28.1%, the highest it has been for six months.

So do not be fooled by talk of the home lending market stalling, it is not so. Even before the RBA’s cash rate cut at the start of May, housing lending of all flavours was significant, and demand will likely rise as lower rates flow through, especially as the stock markets look shaky in May (sell in May and go away…?) and deposit interest rates are being killed.

Economically though, more home lending does not solve our economic growth problem.

NAB enforces tougher foreign lending conditions

From Australian Broker.

NAB has become the third major lender to announce tightened lending conditions for foreign buyers.

The new rules, which come into effect on 14 May, will see NAB only lend 60% of a property’s value to foreign buyers, down from 70% previously.

In addition, the major bank will recognise just 60% of foreign income sources, will no longer be accepting foreign sourced self-employed income, and will be tightening income verification requirements.

In a statement provided to Australian Broker, a NAB spokesperson said: “All foreign home loan applications are considered on a case by case basis and assessed under strict verification standards for employment and income, as well undertaking stringent risk processes.

“These settings are continually reviewed, and controls are tightened where necessary. NAB has limited appetite for this segment which comprises less than 2% of the NAB book.”

One mortgage broker, who asked to remain anonymous, also told the AFR that NAB would not be approving any loans to foreign buyers in “high-risk” areas.

These suburbs have yet to be identified, according to the AFR, but are expected to be inner-city areas in Melbourne and Sydney where there is a surplus of newly built apartments.

NAB’s decision follows announcements by Westpac and ANZ that they will be investigating mortgages backed by questionable foreign-income documentation, which forced them to stop approving such loans last month.

Bendigo and Adelaide Bank and Citigroup have also tightened lending conditions for foreign borrowers in the past week.

Bank of England Warns On Brexit

The latest statement of monetary policy from the Bank of England kept the base rate at 0.5% and to maintained the asset purchases at £375 billion. They said inflation was o.5%, well below the 2% target and growth has slowed in Q1 and is expected to slow further. They say the most significant risks to the MPC’s forecast concern the referendum. A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy.

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target and in a way that helps to sustain growth and employment. At its meeting ending on 11 May 2016 the MPC voted unanimously to maintain Bank Rate at 0.5%. The Committee also voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at

Twelve-month CPI inflation increased to 0.5% in March but remains well below the 2% inflation target. This shortfall is due predominantly to unusually large drags from energy and food prices, which are expected to fade over the next year. Core inflation also remains subdued, largely as a result of weak global price pressures, the past appreciation of sterling and restrained domestic cost growth.

Globally, sentiment in financial markets has improved. There has been a broad-based recovery in risky asset prices, a resumption of capital flows to emerging market economies, and a sharp rise in the price of oil. Near-term prospects for China and other emerging market economies have improved a little, although medium-term downside risks remain. In the advanced economies, growth has picked up in the euro area in Q1 but slowed in the United States. A modest pace of growth in the United Kingdom’s main trading partners is likely over the forecast period, broadly similar to that in the February Inflation Report projections.

In the United Kingdom, activity growth slowed in Q1 and a further deceleration is expected in Q2. There are increasing signs that uncertainty associated with the EU referendum has begun to weigh on activity. This is making the relationship between macroeconomic and financial indicators and underlying economic momentum harder to interpret at present. In the Committee’s latest projections, activity growth recovers later in the year, but to rates that are a little below their historical average. Growth over the forecast horizon is expected to be slightly weaker than in the February projection. The May projection is conditioned on a path for Bank Rate implied by market rates and on continued UK membership of the European Union, including an assumption for the exchange rate consistent with that.

As the dampening influence of past falls in energy and food prices unwinds over the next year, inflation should rise mechanically. Under the same forecast conditioning assumptions described above, spare capacity is projected to be eliminated by early next year, increasing domestic cost pressures and supporting a return of inflation to the 2% target by mid-2018. Thereafter, as in the February Inflation Report, inflation is forecast to rise slightly above the target, conditioned on the path for Bank Rate implied by market rates.

Given the outlook described in the May Inflation Report projections, returning inflation to the 2% target requires achieving a balance between the drag on inflation from external factors and the support from gradual increases in domestic cost growth. Fully offsetting the drag from external factors over the short run would, in the MPC’s judgement, involve too rapid an acceleration in domestic costs, one that would risk being excessive and lead to undesirable volatility in output and employment. Given these considerations, the MPC intends to set monetary policy to ensure that growth is sufficient to return inflation to the target in around two years and keep it there in the absence of further shocks.

Consistent with the projections and conditioning assumptions set out in the May Inflation Report, the MPC judges that it is more likely than not that Bank Rate will need to be higher by the end of the forecast period than at present to ensure inflation returns to the target in a sustainable manner. All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles. This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on economic circumstances. With macroeconomic and financial indicators likely to be less informative than usual in light of the referendum, the Committee is currently reacting more cautiously to data releases than would normally be the case.

The most significant risks to the MPC’s forecast concern the referendum. A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy. Households could defer consumption and firms delay investment, lowering labour demand and causing unemployment to rise. At the same time, supply growth is likely to be lower over the forecast period, reflecting slower capital accumulation and the need to reallocate resources. Sterling is also likely to depreciate further, perhaps sharply. This combination of influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than in the central projections set out in the May Inflation Report. In such circumstances, the MPC would face a trade-off between stabilising inflation on the one hand and output and employment on the other. The implications for the direction of monetary policy will depend on the relative magnitudes of the demand, supply and exchange rate effects. Whatever the outcome of the referendum and its consequences, the MPC will take whatever action is needed to ensure that inflation expectations remain well anchored and inflation returns to the target over the appropriate horizon.

Against that backdrop, at its meeting on 11 May, the MPC voted unanimously to maintain Bank Rate at 0.5% and to maintain the stock of purchased assets, financed by the issuance of central bank reserves, at £375 billion.