Global economic and financial market developments

Global GDP growth picked up during 2016 and has been strong over the past year (Section 1.1). Weighted by countries' shares of UK exports, global growth is estimated to have remained at 0.8% in 2017 Q4. That pace of growth is expected to persist in the near term, above expectations in November. Survey indicators of output (Chart 1.1) and new orders remain robust, particularly in the euro area and United States. Measures of business and consumer confidence are also healthy. Despite further falls in unemployment across a number of countries, inflation remains subdued relative to historical norms (Section 1.2). There are some signs of a recovery in wage growth, however, and further rises in commodity prices are pushing up global inflation.

In light of the recovery in GDP growth, some monetary policy stimulus has begun to be withdrawn across a number of advanced economies, although policy remains supportive. In November, the MPC raised Bank Rate to 0.5%, which has begun to be passed through to retail lending and deposit rates (see Box 2). Market-implied interest rate paths imply a further gradual tightening in policy over the coming years.

The improvements in global growth and confidence since early 2016 have been an important factor supporting rises in risky asset prices in many countries over that period (Section 1.3). Since late January, however, around the time the MPC's projections were finalised, equity prices have fallen sharply and volatility in equity markets has risen.⁽¹⁾

1.1 Global economic developments

In recent years, four-quarter GDP growth has recovered towards pre-crisis rates in a number of advanced economies (Chart 1.2). That pace of growth has been met largely by increased employment, with productivity growth still subdued. As a result, much of the slack in labour markets that opened up following the financial crisis appears to have been absorbed.

With less remaining slack in labour markets, sustaining the recent pace of global GDP growth has therefore become increasingly dependent on a pickup in productivity growth. Current rates of productivity growth, and shortfalls against pre-crisis trends, differ across advanced economies (Chart 1.3). In particular, euro-area productivity growth had begun to slow prior to the crisis, whereas US and UK productivity growth picked up during the early 2000s before slowing more sharply.²

Productivity growth is expected to recover across advanced economies over coming years, but to remain below pre-crisis rates. Investment spending was reined in following the global financial crisis. That continues to weigh on growth in the capital stock — the resources and equipment available to produce output. Investment growth has begun to recover in many countries, however, which will support growth in the capital stock and productivity.

The euro area

Quarterly euro-area GDP growth was robust in 2017 and faster than in preceding years, at 0.6%–0.7% (Table 1.A). That pickup in growth has become increasingly broad-based across countries, supported by an improvement in financial conditions, alongside rises in business and consumer confidence. Business survey indicators, such as the IHS Markit purchasing managers' indices, have risen further in recent months (Chart 1.1). Consistent with that, quarterly GDP growth is projected to be around ¾% in the near term, stronger than projected three months ago (Table 1.B).

The recovery in demand has led to a continuing decline in measures of economic slack. Euro-area unemployment was 8.7% in December, down from 9.7% a year earlier (Chart 1.4), although the extent of the fall in unemployment has varied across countries. As the recent pace of growth continues, unemployment is projected to fall further in the near term.

The United States

At 0.6% in 2017 Q4, US GDP growth was broadly in line with expectations three months ago (Table 1.A). Inventories dragged on growth in Q4, which is unlikely to persist. Business surveys point to quarterly growth of around ¾% in 2018 H1 (Chart 1.1). Personal and corporate tax cuts announced in December are expected to provide a stimulus to activity over the next three years. Those cuts are slightly larger, and take effect earlier, than assumed in November, implying additional support to activity in the near term (Section 5).

Indicators suggest that there is probably little spare capacity remaining in the US economy. A variety of measures of labour market slack — including the unemployment rate (Chart 1.4), underemployment and the rate at which employees are voluntarily leaving jobs — are around their pre-crisis levels.

Emerging market economies

In China, GDP growth continues to be broadly stable (Table 1.A). In 2017 Q4, four-quarter GDP growth was unchanged at 6.8%. Over the past year, activity has been supported by both increased export demand and strong domestic credit expansion. Macroprudential policy measures have led to some slowing in house price inflation and the authorities have continued to take measures to reduce financial sector leverage. There remain challenges for the authorities in maintaining current rates of GDP growth while reducing risks to financial stability.³

Growth in other emerging market economies (EMEs) continued to recover in 2017, supported by: higher capital inflows; the recovery in advanced-economy demand; and, for commodity exporters, the recovery in commodity prices since early 2016. Those factors are expected to underpin slightly stronger growth in EMEs than anticipated in November.

1.2 Commodity markets and developments in inflation

Core inflation — which excludes food and energy prices — remains subdued relative to historical norms in the euro area and United States (Table 1.C). There are some signs of wage growth picking up in those regions, however. And with unemployment set to decline further in the euro area, and seemingly little slack in the United States at present, wage growth and broader inflationary pressures are projected to build over 2018.

Despite subdued core inflation, rises in commodity prices are pushing up headline inflation in the euro area, United States and more widely. As a result, global inflation is a little higher than projected three months ago.

US dollar oil prices have risen fairly steadily since mid-2017, as have industrial metals prices (Chart 1.5). Those rises have in part reflected improvements in global economic activity that have increased demand for commodities. Demand for oil exceeded IEA projections over the second half of 2017, particularly among advanced economies. The rises also reflect supply developments. The supply of oil has risen at a relatively modest pace leading to continued falls in oil stocks. In part, that reflects increased compliance with the late-2016 agreement between OPEC and some non-OPEC oil producers to curb production, which has since been extended to the end of 2018.

By influencing production and transport costs, global commodity prices are also important drivers of the prices of other internationally traded goods. Annual world export price inflation excluding oil is estimated to have slowed to 1.7% in 2017 Q4 (Table 1.C). The more recent rises in commodity prices are, however, set to push up world export prices and therefore UK import price inflation slightly in the near term (Section 4).

1.3 Developments in financial markets

Exchange rates

In the run-up to the February Report, the sterling ERI was 3% higher than at the time of the November Report, although 16% below its November 2015 peak. The recent rise has largely been relative to the US dollar, which has depreciated against other major currencies. More broadly, sterling has remained around 15%–20% below its pre-referendum peak (Chart 1.6), and has been no more volatile than in previous periods following significant revaluations.

Interest rates

The improving growth outlook has begun to put upward pressure on short-term market interest rates across advanced economies over the past year, as expectations have built that central banks will withdraw some of the stimulus provided by monetary policy. Market-implied paths for policy rates have risen further since November (Chart 1.7).

At its December meeting, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate to between 1¼% and 1½% (Chart 1.7). That was the third 25 basis point increase in the target range during 2017. The median of FOMC members' projections implies another 75 basis points of tightening during 2018. In addition, and as announced in September, the Federal Reserve's balance sheet has started to shrink as a proportion of maturing assets are not being replaced.⁴

The European Central Bank (ECB) has made no changes to its policy rates since November (Chart 1.7). The market-implied path is also broadly flat over 2018. The ECB has continued with its asset purchase programme, although, as announced in October, the pace of purchases has been reduced from €60 billion to €30 billion per month since the beginning of 2018.

In the United Kingdom, the MPC raised Bank Rate to 0.5% in November. In the period when the MPC was finalising its February projections, the market-implied path for Bank Rate reached 0.75% in 2018 Q4 and just under 1¼% in three years' time (Chart 1.7). The MPC voted to make no changes to monetary policy at its December meeting, as set out in Box 1. The details of the February decision are contained in the Monetary Policy Summary and in more detail in the Minutes of the meeting.

Longer-term interest rates have risen in recent months (Chart 1.8). Those rates had been broadly flat over much of 2017 — albeit at higher levels than in 2016, on average. Although rates were broadly flat, model-based estimates suggest that expected policy rates continued to rise during 2017, but were offset by falls in term premia. Term premia have risen more recently, although they remain relatively compressed. Term premia capture the additional compensation that investors require for holding long-term bonds and therefore reflect market participants' perceptions of the risks and uncertainties around future interest rates. Market contacts cite the global inflation environment and the prospect of increases in government bond issuance, net of central bank asset purchases, over the coming year as potential sources of the recent rise.

More broadly, continued historically low long-term interest rates in large part probably reflect slow-moving structural factors such as demographics. Those factors are likely to continue to weigh on global interest rates for some time to come.⁵ Consistent with this, market-implied paths suggest that policy rates will rise by a limited amount in coming years (Chart 1.7), particularly in comparison to previous tightening cycles.

Corporate capital markets

Developments in capital markets influence the ease and cost of raising finance for companies. Equity prices rose sharply in late 2017 and early 2018, particularly in the United States (Chart 1.9). The recently announced US tax cuts (Section 1.1) appeared to boost US equities in particular, while rises in commodity prices (Section 1.2) supported the equity values of companies within the energy sector. Since late January, however, around the time the MPC's projections were finalised, equity prices have fallen back and volatility in equity markets has risen. Market contacts describe those falls as initially prompted by perceptions of increased inflationary risks.

Equity prices in most countries remain higher than in mid-2016, supported by the improvements in global growth and confidence (Section 1.1). Much of the rise in the FTSE All-Share index over that period (Chart 1.9), however, has reflected the decline in the exchange rate and its impact on the sterling value of profits earned in UK-listed companies' overseas operations. Consistent with that, the equity prices of UK-focused companies within the index have been broadly unchanged (Chart 1.9).

Despite rises in government bond yields, corporate bond yields have fallen over the past couple of years, reducing the cost of bond financing. The corporate bond spread is therefore lower than in early 2016 (Chart 1.10), particularly for 'high-yield' debt, which is issued by companies perceived as riskier. Spreads on riskier high-yield sterling bonds have narrowed by less than their dollar and euro equivalents since early 2016, however.

Bank funding costs

Capital markets also matter for broader credit conditions through their influence on bank funding costs. Although they have been broadly stable over the past six months, the spreads that banks pay for funding over and above market interest rates have narrowed significantly since early 2016 (Chart 1.11). That narrowing appears largely to have reflected the broader improvement in global financial markets.

To ensure bank lending rates remain closely linked to official policy rates, the Term Funding Scheme (TFS) was introduced in August 2016 to provide funding at close to Bank Rate for lenders that maintained or increased net lending, with a penalty rate for banks that reduced net lending. While the TFS drawdown window will close this month, existing TFS drawings will remain in place for up to four years.

In addition to debt, banks can also raise funds through equity financing, and financial policy can influence the mix of funding. At its November meeting, the Financial Policy Committee (FPC) decided to increase the countercyclical capital buffer rate, levied on banks' total risk-weighted UK assets, from 0.5% to 1%.⁶ The setting of the countercyclical buffer will not require banks to strengthen their capital positions. It will require them to incorporate some of the capital they currently have in excess of their regulatory requirements into their regulatory capital buffers.

The narrowing in funding spreads over recent years has contributed to low levels of retail interest rates (Chart B in Box 2). The recent rise in Bank Rate and increases in its market-implied path are expected to feed through gradually into higher rates for households and companies. Nevertheless, overall, bank funding costs and retail interest rates remain low by historical standards.

• Notes

  1. All financial market data shown in charts within this section are to 31 January 2018.

  2. For further detail on the factors driving those trends, and for the United Kingdom in particular, see Tenreyro, S (2018), 'The fall in productivity growth: causes and implications'.

  3. For more detail on financial vulnerabilities in China, see the November 2017 Financial Stability Report.

  4. For further detail see page 4 of the November 2017 Inflation Report.

  5. For further discussion, see the box on pages 8–9 of the November 2016 Inflation Report; Vlieghe, G (2016), 'Monetary policy expectations and long-term interest rates'; and Vlieghe, G (2017), 'Real interest rates and risk'.

  6. For further detail on the FPC's decision, see the November 2017 Financial Stability Report.