Global economic and financial market developments

1.1 Global economic developments

Weighted by countries' shares in UK exports, global activity growth is expected to have slowed in Q3 to 0.5% (Table 1.A). That is a little weaker than expected at the time of the August Report and somewhat slower than the strong rates seen in 2017. Global growth remains relatively robust, however, with most of the world still growing at rates above estimates of potential growth in 2018 H1 (Chart 1.1).

Growth has been particularly strong in the US, boosted in part by an easing in fiscal policy. In contrast, euro-area growth has slowed in 2018, and by more than expected. That divergence in regions has also been apparent in capital markets and exchange rates. For example, equity prices have fallen markedly in the euro area in 2018 so far, unlike in the US. Strong US growth and a related monetary policy tightening have led to a rise in interest rates and a strengthening in the US dollar. Those developments have pushed up forward interest rates in other advanced economies, including the UK (Section 1.2), and have been associated with a tightening in financial conditions in many emerging market economies, which is weighing on the growth outlook there.

Signs of slowing global growth are apparent in indicators of global trade and investment growth, albeit from recent strong rates. World goods trade growth has moderated in 2018 (Chart 1.2). Consistent with that, survey indicators of activity in manufacturing and export-focused sectors have weakened (Chart 1.3). In addition, growth of capital goods orders — an indicator of investment — in the euro area and US has slowed.

One factor that is likely to weigh on the outlook for global activity is the prospect of trade protectionism. Tariffs applied by the US on Chinese imports, and broader aluminium and steel tariffs announced earlier in the year, have been met with reciprocal measures. Since August, the US has also proposed further increases in tariffs on Chinese imports. However, trade tensions between the US and some of its trading partners have eased somewhat, with Canada, Mexico and South Korea agreeing trade deals with the US. As discussed in Box 1, both potential and realised barriers to trade are likely to affect activity and inflation in the countries involved and, indirectly, elsewhere.

Consistent with some moderation in global activity growth and a pickup in trade tensions, prices of many commodities have fallen through the course of this year. Metals prices, in particular, are down 12% since January, though they have been more stable in recent months (Chart 1.4). In contrast, oil prices have risen over the past three months. That recent pickup mostly reflected the prospect of limited oil supply growth in coming quarters.

Global growth is expected to remain broadly stable in coming quarters, at a little above potential. The effects of tighter financial conditions, given monetary policy normalisation in advanced economies and a recent deterioration in global risk sentiment, are likely to continue affecting the pace of growth. And some direct effects from higher tariffs and the fading of the boost from US fiscal policy are also expected to weigh on growth (Section 5).

The United States

Activity growth in the US has been strong in 2018 so far, and slowed only slightly in Q3 to 0.9%, from 1.0% in Q2 (Table 1.A). That was a more modest slowdown than had been expected at the time of the August Report. Activity growth in 2018 has been underpinned by solid consumption growth, with consumer confidence remaining high (Chart 1.5). In coming quarters, US growth is expected to slow somewhat, but to remain above potential (Table 1.B).

Strong domestic demand has been supported in part by fiscal policy. Personal and corporate tax cuts were announced in December 2017, and the Bipartisan Budget Act of 2018 lifted discretionary spending caps by around US$300 billion over 2018 and 2019, equivalent to around 1.5% of GDP. The fiscal measures announced can be expected to support demand growth only for so long. That support is expected to peak in 2019 before fading thereafter. Spending caps are legislated to return to 2017 levels in 2020, implying falls in spending that would drag on growth. However there is uncertainty around the profile for fiscal policy.

Net trade weighed on growth in Q3 and is expected to continue doing so in coming quarters. Weak export growth may partly reflect the appreciation of the US dollar over 2018 (Chart 1.6). In addition, as discussed in Box 1, the prospect of trade protectionism is likely to weigh on the outlook. Although only recently implemented, there are already signs that the higher tariffs on US trading partners and associated reciprocal measures may have affected export activity. For example, the PMI measure of new export orders has fallen (Chart B) in Box 1), with many respondents citing concerns over tariffs. Rising trade tensions, alongside the moderation in the global outlook, also appear to have affected sentiment, with business confidence falling in Q3 (Chart 1.5).

Strong growth in activity in 2018 has reduced the degree of spare capacity in the US economy, and it is judged to be in excess demand. The headline unemployment rate fell to 3.7% in September, and other measures of slack, such as the rate of unemployment plus marginally attached and part‑time workers, were also close to historical lows. The fall in unemployment in recent years has been associated with steady employment growth. At the same time, the labour force participation rate has been stable, with the long‑term drag from an ageing population having been offset by a pickup in the participation rate of those aged 25–54. That is expected to continue in coming years. Consistent with tightness in the labour market, wage growth has risen over the past year (Table 1.C). That has probably contributed to a pickup in core inflation, which is a little above past averages.

Given robust demand growth and the prospect of sustained inflationary pressures, the Federal Open Market Committee (FOMC) has continued to tighten monetary policy. The Committee raised the target range for the federal funds rate to 2%–2¼% in September. The path of policy implied by market prices has risen since August (Chart 1.7), as have long-term interest rates (Chart 1.8). Market contacts attributed those increases in part to the strengthening growth outlook and greater evidence of inflationary pressures. In addition, communication by some FOMC members suggesting a tighter path for monetary policy than had previously been expected appears to have pushed up expectations of future policy rates. The Federal Reserve also continued to reduce the size of its balance sheet, which was US$300 billion lower than its September 2017 peak in the run-up to the November Report.

China

Quarterly GDP growth in China slowed slightly to 1.6% in Q3 (Table 1.A), as expected in August. Some activity indicators such as export order PMIs point to a further modest slowing in Q4. Credit growth has also slowed gradually, particularly from the non-bank sector, although it remains relatively robust.

Rising trade tensions with the US are likely to weigh on the outlook in coming quarters. Market contacts attributed falls in asset prices over 2018 to the anticipation of the impact of higher trade barriers, as well as associated uncertainty. The Shanghai Composite equity index is around 5% lower than at the time of the August Report, and around 20% lower over 2018 so far (Chart 1.9). Although the renminbi has been more stable in recent months, as authorities have taken some steps to support the exchange rate, it remains weaker than at the start of the year (Chart 1.6).

Growth is expected to moderate slightly to 1.5% in coming quarters. Fiscal spending and relatively robust credit growth are expected to support activity. For example, net issuance of local government bonds used to finance infrastructure projects has increased substantially. And the People's Bank of China (PBoC) has created additional room for banks to expand credit by progressively cutting the reserve requirement ratio — the reserves that Chinese banks are required to keep with the PBoC. As discussed in the Financial Policy Committee's June Financial Stability Report, there remain challenges for the Chinese authorities in maintaining robust rates of GDP growth while continuing to reduce risks to financial stability.

Non-China emerging market economies

Excluding China, emerging market economy (EME) growth slowed in 2018 Q2 to 0.9% on a PPP-weighted basis, broadly as expected in the August Report. It is expected to have slowed further in Q3. Consistent with that, manufacturing PMIs and growth in measures of industrial production have softened throughout 2018 across the largest non-China EMEs, albeit from robust levels (Chart 1.10).

Tighter financial conditions in non-China EMEs (Chart 1.11), largely reflecting the impact of the normalisation of US monetary policy, have contributed to weaker activity growth in those economies. This follows a period of relatively loose financial conditions during which some EMEs substantially increased their issuance of government or corporate debt denominated in foreign currencies, particularly US dollars. Unless borrowers have revenues in US dollars, or have hedged themselves against exchange rate moves, those debts become costlier to service if the dollar appreciates, as it has done in 2018 (Chart 1.6). In addition, absent a change in policy rates in EMEs, higher US policy rates will reduce the relative return on EME assets and, in turn, external demand for those assets.

Those effects are likely to have been exacerbated by the increase in trade tensions between the US and its trade partners over 2018. As discussed in Box 1, the integration of many EMEs into global supply chains will expose them to potential trade disruption.

Associated with that tightening in financial conditions has been a net flow of portfolio capital out of non-China EMEs since 2018 Q1 (Chart 1.12). Since the financial crisis, non-bank lending has accounted for all of the increase in foreign lending to EMEs,¹ which — as discussed in the June Financial Stability Report — may have made capital flows more sensitive to changes in financial conditions. Although net outflows moderated in Q3, lower investor appetite for EME assets has continued to weigh on asset prices, with spreads on government and corporate bonds wider (Chart 1.12) and equity prices lower (Chart 1.9) over 2018. In addition, to support exchange rates and capital inflows, a number of central banks, for example in Russia, India and Indonesia, have raised their policy rates, further tightening financing conditions in those countries.

The impact of tightening global financial conditions has been particularly pronounced in Argentina and Turkey. Both countries are particularly reliant on external capital — with US dollar-denominated debt amounting to over 40% of GDP, much of it short term — and so are sensitive to the tightening in financial conditions. Those vulnerabilities have been amplified by domestic factors. For example, market contacts attributed sharp moves in asset prices during 2018 in part to domestic monetary policy developments in both countries, while weak growth in Argentina has also reflected the effects of severe drought. Despite those specific domestic circumstances there remains a risk of contagion to other emerging markets, for example if investors seek to rapidly reduce their exposures to EMEs more generally as a result.

As the recent tightening in financial conditions continues to weigh on activity, non-China EME growth is projected to remain around current rates in coming quarters, weaker than expected in August (Table 1.B). That deterioration in the outlook reflects the projected sharp slowing in growth in Argentina and Turkey, as well as the impact of the tightening in financial conditions elsewhere. That said, financial conditions remain close to past averages (Chart 1.11), and growth is expected to remain a little above estimates of potential growth in aggregate.

Euro area

Quarterly euro-area GDP growth slowed to 0.2% in 2018 Q3, from 0.4%. That was lower than expected in August, and substantially lower than average growth rates of 0.7% over 2017. Although activity growth is expected to pick up, the projected path for growth in coming quarters has been revised down (Table 1.B), and is only a little above estimates of potential growth.

The slowdown in growth in 2018 has been broad-based across the large euro‑area economies. The contribution from net trade, which had driven much of the strength in 2017, has fallen in most countries in the first half of 2018. And net trade is expected to continue to be weak in coming quarters as the global outlook moderates. Consumption and investment growth had continued to support growth in 2018 H1, with survey measures of consumer and business confidence well above average, but these measures have softened in 2018 Q3 (Chart 1.5).

The euro-area unemployment rate has continued to fall, to 8.1% in September, its lowest since 2008 Q4. Consistent with a steady reduction in slack, wage growth has picked up in 2018 H1 (Table 1.C). Some spare capacity is judged to remain, however, with unemployment still above its estimated equilibrium rate. And core inflation remains subdued.

The European Central Bank (ECB) made no changes to policy rates in September or October and reiterated its past guidance that rates were expected to remain at present levels at least through the summer of 2019. However, the market-implied path for policy rates has steepened somewhat since August (Chart 1.7), which market contacts attributed in part to an upward shift in short-term interest rates globally. Most long-term interest rates in the euro area also increased over that period (Chart 1.8). Long‑term interest rates on Italian government debt have increased particularly sharply due to political developments. There was little evidence that had spilled over to other euro-area countries, however.

1.2 UK financial conditions

Having already tightened steadily over 2018, UK financial conditions have tightened slightly further since August, though they remain accommodative overall. Bank Rate and market interest rates have risen from low levels, and that is feeding through to the rates facing households and companies. Moves in equity prices and corporate bond spreads have also raised the cost of funding for companies, reflecting a decline in risk sentiment as the global outlook has moderated. UK asset prices remain sensitive to developments related to the UK's withdrawal from the EU.

Market interest rates

In August, the MPC raised Bank Rate to 0.75%. That had been anticipated well ahead of the announcement with most short-term interest rates rising earlier in 2018 (Chart 1.13). The MPC voted to make no changes to monetary policy at its September meeting (Box 2). In the run-up to the November Report, stronger‑than‑expected activity and inflation outturns, as well as increases in short‑term interest rates internationally, have pushed up the market-implied path for Bank Rate. It is now expected to reach around 1.4% in three years' time, up from 1.1% in August (Chart 1.7).

Long-term UK interest rates have also risen since August, despite falling back in the run-up to the November Report (Chart 1.8). Those rates have been affected in part by the increase in long-term interest rates in other countries.

Retail interest rates

The rise in Bank Rate in August, and the associated rise in short-term risk-free rates earlier in the year, have pushed up most bank lending rates. The average interest rates on new variable rate lending — which account for most corporate lending and around 10% of new mortgage lending — have risen since the time of the August Report (Table 1.D). Interest rates on new fixed-rate mortgage lending rose earlier in the year as the relevant risk-free rates upon which those are benchmarked rose in anticipation of the change in Bank Rate (Chart 1.13).

The pickup in the cost of bank funding in wholesale markets over 2018 (Chart 1.14) should also place upward pressure on retail lending rates. The rise in bank funding costs appears to have been largely driven by the same factors that have pushed up spreads in corporate bond markets more generally, such as a fall in global risk sentiment. In addition, as discussed in the June Financial Stability Report, stronger bank debt issuance has added to the upward pressure on funding spreads. That increased issuance reflects, in part, the need for banks to meet incoming regulatory requirements, as well as the end of the drawdown window for the Term Funding Scheme in 2018 Q1.

Despite some increase in most mortgage lending rates over 2018, the average rate on new lending remains lower than mid-2016 (Chart 1.15). That largely reflects the effects of increased competition in the retail banking market as lenders have reduced margins on some products to maintain market share. As a result, the average rate paid on the stock of outstanding lending remains much lower than in the first half of 2016 (Chart 1.15), despite the more recent pass-through of higher risk-free rates.

Deposit rates have generally risen by less than the pickup in risk‑free rates over 2018, and are expected to adjust only gradually in coming quarters. That partly reflects developments since the financial crisis. Prior to 2008, sight deposits were several percentage points below Bank Rate and lending rates (Chart 1.15). But as there are limits to banks' capacity to lower deposit rates below 0%, deposit rates did not fall as much as Bank Rate during the crisis. As Bank Rate rises, the corresponding rise in deposit rates is therefore likely to be somewhat less as the spread between deposit rates and Bank Rate normalises.

Developments in other components of banks' balance sheets may also influence the path for deposit rates. On the asset side, to the extent that competition continues to weigh on lending rates, banks may moderate the pickup in interest paid on the stock of deposits to mitigate any erosion of their margins. Acting in the opposite direction, however, the recent pickup in wholesale market bank funding costs may increase banks' demand for retail deposits and push up deposit rates over time.

Corporate capital markets

Many large UK companies use both domestic and international markets to raise funding. Spreads on corporate bonds across the main markets in which UK companies borrow have been broadly stable since the August Report but remain wider than they were at the start of 2018 (Chart 1.16). Market contacts have cited a number of drivers of the widening in spreads, including the fall in global risk sentiment, the prospective end of the ECB's corporate bond purchase programme and US corporate tax reform in early 2018, which encouraged share buybacks among US companies and may have reduced demand for European debt.

Despite this widening over 2018, corporate bond spreads remain at low levels comparable with those seen before the financial crisis. Moreover, as discussed in the June Financial Stability Report, in some corporate bond markets, particularly in the US, those low spreads have been accompanied by an easing in non-price terms, such as weaker covenants. The recent pickup in leveraged lending, including in the UK (Section 2), has also been accompanied by an increased share of deals with weaker covenants.

Equity prices fell in the run-up to the November Report (Chart 1.9). Investor risk sentiment has deteriorated in part due to geopolitical developments. In addition, the prospect of a higher path for US interest rates has also weighed on equity prices. Among UK-listed companies, the equity prices of those with a substantial focus on the euro area — defined as companies with more than 40% of revenue derived from the euro area — have underperformed other companies substantially since June, perhaps reflecting increased uncertainty around the potential impact of the UK's withdrawal from the EU.

Sterling

In the run-up to the November Report, the sterling ERI was 1% higher relative to three months ago (Chart 1.6). It remained 16% below its November 2015 peak, however.

As has been the case since the referendum, sterling will be particularly responsive to developments related to the UK's withdrawal from the EU. Implied volatilities from sterling options — measures of perceived risk around the exchange rate — have risen recently (Chart 1.17). And movements in the cost of insuring against a large depreciation relative to a large appreciation — known as the risk reversal — suggest that the weight market participants are placing on a future depreciation has risen (Chart 1.17).

• Notes
  ¹ For more details see Carney, M (2018), 'True Finance — Ten years after the financial crisis'.

Box 2: Monetary policy since the August Report

The MPC's central projection in the August Report was for GDP to grow by around 1¾% per year on average over the forecast period. Although modest by historical standards, that growth rate was slightly faster than the diminished rate of supply growth, which was projected to average around 1½% per year. As a result, a small margin of excess demand was projected to emerge by late 2019 and build thereafter, feeding through into higher growth in domestic costs than had been seen over recent years. The contribution of external cost pressures, which has accounted for above-target inflation since the beginning of 2017, was projected to ease over the forecast period. Taking these influences together, and conditioned on a gently rising path for Bank Rate, CPI inflation was projected to remain slightly above 2% through most of the forecast period, reaching the target in the third year.

At its meeting ending on 12 September 2018, the MPC noted that recent news in UK macroeconomic data had been limited and the MPC's August projections appeared to be broadly on track. UK GDP grew by 0.4% in 2018 Q2 and by 0.6% in the three months to July. The UK labour market had continued to tighten, with the unemployment rate falling to 4.0% and the number of vacancies rising further. Regular pay growth had risen further to around 3% on a year earlier. CPI inflation was 2.5% in July.

The global economy still appeared to be growing at above‑trend rates, although recent developments were likely to have increased downside risks around global growth to some degree. In emerging market economies, indicators of growth had continued to soften and financial conditions had tightened further, in some cases markedly. Recent announcements of further protectionist measures by the United States and China, if implemented, could have a somewhat more negative impact on global growth than was anticipated at the time of the August Report.

The MPC continued to recognise that the economic outlook could be influenced significantly by the response of households, businesses and financial markets to developments related to the process of EU withdrawal. Since the Committee's previous meeting, there had been indications, most prominently in financial markets, of greater uncertainty about future developments in the withdrawal process.

The Committee judged that, were the economy to continue to develop broadly in line with the August Report projections, an ongoing tightening of monetary policy over the forecast period would be appropriate to return inflation sustainably to the 2% target at a conventional horizon. As before, those projections were conditioned on the expectation of a smooth adjustment to the average of a range of possible outcomes for the United Kingdom's eventual trading relationship with the European Union.

The Committee judged that the current stance of monetary policy remained appropriate. Any future increases in Bank Rate were likely to be at a gradual pace and to a limited extent.