BOE ties its rate path to Brexit after first hike in decade

[LONDON] Mark Carney is tying the Bank of England's (BOE) next interest-rate shift to the success of Brexit negotiations.

After raising interest rates for the first time in more than a decade on Thursday, the governor of BOE said the pending divorce from the European Union (EU) is the main risk to the outlook, aggravating existing weaknesses that have hobbled the economy and holding back potential growth.

It affects how "businesses and households think about the future, think about their investment plans, spending plans," Mr Carney said.

"It will have certainly an impact on a range of financial asset prices, notably the exchange rate. And we as a committee will have to step back and assess the new outlook and calibrate policy appropriately."

By linking the future path of rates to the outcome of the talks, Mr Carney has upped the stakes for the UK's team of negotiators, who remain deadlocked with their European counterparts. Prime Minister Theresa May, now distracted by a Westminster sex scandal that has already prompted the resignation of one minister, has just weeks to come up with a proposal to the EU on a divorce bill payment, the main sticking point before negotiations proceed.

"There did appear to be a more cautious tone on Brexit," said Victoria Clarke, an economist at Investec in London. "It certainly appears as if there's some more Brexit news, some more certainty, to be received before they're content to make any next move."

Mr Carney littered his press conference with references to the extraordinary circumstances the BOE is facing, saying these are "exceptional" and "not normal" times. He noted the "unique elements that we're grappling with" and said the UK is in "an unusual period of under-performance" given the strength of other industrialised economies.

The BOE chief said most UK companies are expecting a transitional arrangement with the EU and aren't making preparations for a no-deal Brexit, a scenario even the government is preparing for. He added that as more clarity emerges, the bank is likely to reassess its current outlook. That will have implications for its response on borrowing costs - and up isn't the only direction.

"If that's an acceleration in the pace of raising interest rates - because the balance of demand and supply and exchange rate effects warrant it - that is an appropriate response," Mr Carney said.

"If it requires some more support for the economy, again, because of a mixture of those exchange rate, supply and demand effects, in our judgement, that again is a nimble, appropriate response."

The BOE raised its key rate to 0.5 per cent from a record-low 0.25 per cent on Thursday, reversing the cut it made in the aftermath of the EU vote last year. In their statement, officials dropped a line that more increases could be needed than markets expect, implying they're broadly comfortable with two more quarter-point moves in the next three years.

The assessment behind Thursday's hike was far from upbeat. Inflation is being partly boosted by tightness in the supply side of the economy, which is growing around a now-lower potential rate of 1.5 per cent. That's because of poor productivity, which isn't likely to improve as Brexit undermines investment and reduces immigration.

Analysts at Bloomberg Economics predict no more rate increases until the UK leaves the EU in 2019. They also said uncertainty "is likely to mean companies are reticent to invest in capacity either at home or abroad".

At the same time, Krishna Guha of Evercore ISI said a breakthrough in the talks could lead to the start of a more traditional rate-hiking cycle. A Brexit deal would prompt businesses and consumers to "shift in a way that would liberate the bank to move beyond the cautious extent of its move", he said in a report.

The BOE's gloom may revive the criticism Mr Carney received because of previous forays into the politically-charged debate, when some lawmakers accused him of partisan commentary. Still, he's previously indicated he won't ignore the issue, telling an audience including the prime minister in September that the BOE would continue to express its independent assessment.

"A little more or less progress will matter for the economy to the extent to which people change their attitudes and change their spending plans, both positively and negatively," Mr Carney said on Thursday. Any agreement will be a "focal point for people to stop, reassess, recalibrate, move forward - ideally with some plans that have been delayed or deferred - and then we would take that into account."

BLOOMBERG