Global developments and domestic financial conditions

1.1 Global economic developments

Since May, the outlook for global growth has deteriorated a little. In 2019 Q2, UK-weighted world GDP growth appears to have slowed slightly to 0.4% (Table 1.A), slightly lower than expected in May. US and euro-area GDP growth both slowed, following surprising strength in Q1, to 0.5% and 0.2% respectively. Growth in emerging markets has been weaker than projected in the May Report, having slowed in the past year reflecting a previous tightening in financial conditions.

Higher-frequency indicators further suggest that global output growth may have weakened in recent months. Global PMIs have continued to fall since May, particularly in the manufacturing sector, where the output index has dipped below 50 (Chart 1.1). Forward-looking surveys suggest that growth is likely to stabilise in the near term. For example, the manufacturing export orders index has remained at a similar level over the past three months (Chart 1.1).

Softer global growth — particularly in the manufacturing sector — is likely at least in part to reflect the impact of trade tensions, which have increased over the past year and intensified further since May. The US and China both implemented higher tariffs over 2018, with the US applying tariffs to US$250 billion of imports from China, and China reciprocating with tariffs on US$110 billion of imports from the US. Tariffs were due to increase in 2019, but at the time of the May Report, those were not assumed to be implemented, given that trade talks between the two countries appeared to be progressing positively. Trade talks subsequently broke down, however, and tariffs were increased.

As well as the tariffs implemented so far, other developments have added to concerns about trade protectionism. For example, the US announced plans to impose further tariffs on all remaining imports from China, although in June both parties agreed to continue talks. The US administration is also considering whether to impose tariffs on automotive products, including those imported from the EU, with a decision expected later this year.

Trade tensions are likely to have affected the global economy through both direct and indirect channels. Tariffs introduced by the US and China have had a direct effect on their bilateral goods trade, with both Chinese imports from the US and US imports from China having fallen in the year to 2019 Q1. There are also likely to have been wider indirect effects via reduced global business confidence. Sentiment in the manufacturing sector has fallen over the past year, consistent with weaker world trade growth (Chart 1.2). Indicators of uncertainty about economic policy, including trade policy, have also picked up (Chart 1.3). That is likely to have weighed on investment, which has been a key driver of the recent slowdown in advanced-economy growth. Consumption growth has remained resilient, however.

Over the forecast as a whole, trade tensions are expected to drag on GDP growth by more than was assumed in May. Tariffs are projected to reduce GDP in the US by 0.5%, and in China by 0.4% once some offset from looser policy is incorporated. The overall impact is to lower PPP-weighted world GDP by 0.2% via direct channels, which weighs on UK GDP growth by 0.1%. It is also likely that there have been spillovers via business confidence, although the MPC’s central forecast assumes that they are only modest. A severe shock could lead to a much larger impact (Table 1.B).¹

Price pressures in major advanced economies have been subdued. Inflation has remained weak in the euro area recently (Table 1.C). It was 1.3% in June, below the European Central Bank’s (ECB’s) target, despite a pickup in unit labour cost growth over the past year to above its pre-crisis average. Inflation in the US was close to 2% during most of 2018, but it was below the Federal Reserve’s target in June 2019 at 1.4%. The Federal Open Market Committee (FOMC) has noted, however, that transitory factors such as financial services fees and a methodological change to clothing price collections may be weighing on measured inflation.

Measures of inflation expectations derived from financial market prices have also fallen in the euro area and the US. In the euro area, the five-year inflation swap rate, five years forward, has fallen by around 40 basis points since late 2018 (Chart 1.4) to an all-time low in June. The equivalent measure in the US has also fallen over that period, but its level is higher at around 2%. By contrast, UK inflation swap rates have changed little since May (Section 4).

Weaker-than-expected activity data, trade tensions and low inflation may all have contributed to the marked fall in the market-implied paths for policy rates in the US and euro area (Chart 1.5). Nonetheless, the fall in US forward interest rates appears large relative to the news in the data and the estimated impact of the tariffs implemented to date. It is therefore possible that the falls in US forward interest rates also reflect perceptions of increased risks around the global outlook — for example that tariffs increase further — as well as a weaker central projection for global growth.

Lower interest rate expectations may also reflect central bank communications. In the euro area, interest rate expectations fell sharply after the President of the ECB stated that additional stimulus would be required if inflation fails to return to the target. In the US, the median projection of FOMC participants for the federal funds rate at the end of 2020 fell from 2.6% in March to 2.1% in June, indicating a lower expected path for interest rates. [The FOMC then reduced its target range for the federal funds rate at its July meeting.] There has been little change to monetary policy in China since May, although fiscal policy has been loosened significantly since the start of the year.

The fall in market-implied paths for interest rates has supported equity prices. Equity prices were slightly higher in the US in the run-up to this Report than in May. They were broadly unchanged in the euro area, but a little lower across emerging markets (Chart 1.6). Over the period as a whole, corporate bond spreads are little changed. Overall, global financial conditions are estimated to be looser than at the time of the May Report, reflecting the fall in forward interest rates in advanced economies, which are likely to contribute to looser financial conditions in emerging markets.

In the MPC’s projection, the easing of global financial conditions supports a gradual pickup in world GDP growth to its potential rate. The forecast is nonetheless a little weaker than in May. That reflects the downward impact of higher tariffs and the related effect of weaker sentiment (Section 5).

• Notes

  1. For details, see Carney, M (2019), ‘Sea change’.

1.2 Domestic financial conditions

Market interest rates, sterling and equity prices

The market-implied path for Bank Rate has fallen over the past three months, continuing its decline since late 2018. It now implies a 25 basis point cut in Bank Rate over the coming year (Chart 1.5). Over the forecast period, the market implied path is on average around 70 basis points lower than in November and around 30 basis points lower than in May. Long-term UK interest rates have also fallen by around 40 basis points since May.

Bank staff analysis suggests that the decline in UK forward interest rates since May can partly be attributed to global factors. For example, trade tensions and perceived downside risks to the global economy may have driven investors towards risk-free assets such as government bonds, reducing the yields on those assets.

Lower interest rates also reflect changing views among market participants about the probabilities of different Brexit outcomes. The latest betting odds suggest that the perceived probability of no deal has risen. The Reuters survey, which asks respondents about the probability of a disorderly Brexit, suggests that probability has also risen materially since May. As the weight attached to the possibility of a no-deal Brexit has increased, financial market participants have marked down their expectations for the path of interest rates.

Financial market participants’ expectations that the economy would be weaker in the event of a no-deal Brexit also mean that the sterling exchange rate tends to depreciate as the probability of a no-deal Brexit rises. The sterling ERI has fallen by 4% since the May Report (Chart 1.7). Sterling implied volatility has increased since May and the cost of insuring against a large depreciation - known as the risk reversal - has also risen. Since the forecast was finalised, sterling has depreciated further by around 2%, while sterling implied volatility and the risk reversal have increased a little more.

The growing perceived probability of a no-deal Brexit has put downward pressure on the equity prices of UK-focused companies (Chart 1.6). In contrast, the equity prices of UK-listed companies with significant overseas operations have risen, such that the FTSE All-Share index has been broadly unchanged. Because much of those companies’ profits is earned in foreign currency, their sterling value is mechanically boosted by the exchange rate depreciation.

Credit conditions facing companies and households

Corporate credit conditions were little changed in 2019 Q2. Corporate bond spreads across the main markets in which UK companies borrow are broadly similar to those at the time of the May Report. The cost and availability of bank lending to companies was also little changed in Q2, according to the Credit Conditions Survey. Contacts of the Bank’s Agents reported some tightening in credit conditions for firms in a few sectors, for example construction and high-street retail.

For households, most mortgage rates were unchanged over 2019 Q2, and have now been stable for over a year. That is despite spreads on unsecured bank funding having fluctuated substantially. As discussed in Box 1 of the February 2019 Report, wholesale unsecured funding spreads are likely to be less important for retail banks’ loan pricing than in the past. That is because the large retail banks have increased their share of deposit funding — particularly sight deposits — relative to wholesale funding.

Although rates on consumer credit have been little changed since the run-up to the May Report (Table 1.E), there has been some tightening in credit conditions in the unsecured lending market. Credit card rates have increased over the past year, and respondents to the Credit Conditions Survey have been reporting falls in the availability of unsecured credit, as well as tighter credit scoring criteria, for some time. Respondents also reported that default rates on unsecured lending had risen for the third consecutive quarter in 2019 Q2. Supervisory intelligence indicates that default rates nevertheless remain at low levels, and other indicators of household distress have not worsened.

Overall domestic financial conditions

A summary measure of UK financial conditions suggests that conditions have loosened since May (Chart 1.8). That reflects the fall in market interest rates and the sterling ERI, partly offset by higher credit spreads as banks have not yet passed through the fall in risk-free rates to lending rates.

That easing in financial conditions provides some support to UK growth in the MPC’s forecast compared with the May Report. Market movements have been partly driven by an increase in the perceived likelihood of a no-deal Brexit, however, which is not consistent with the MPC’s forecast conditioning assumption of a smooth Brexit. That tension is discussed further in Box 6 in Section 5.