The dilemma for the Bank of England (BoE) intensifies in light of this morning’s May employment figures. UK unemployment has fallen further to 4.5%, versus the BoE forecast at 4.7%. To find a similarly low level you have to go back to the mid-70s, as shown in Chart 1. Moreover, the current level of unemployment is below where the BoE sees the natural level (the level of unemployment below which inflation should rise), all at a time when monetary policy is at emergency levels and inflation is well above the target.

Chart 1: UK unemployment

Source: Bloomberg as at 11 July 2017

And unlike in the US where the participation rate has been coming down, in the UK it has been increasing. Over the last three months the economy has created an impressive 175,000 jobs, taking the overall employment figure to 32m people, 324,000 higher than last year. The employment rate is 74.9%, the highest since comparable records began in 1971.

But employment is not the full story.

Real disposable income for UK consumers continues to be challenged by elevated headline inflation and low earnings. Leaving aside employment, the macroeconomic data has been surprising to the downside (Chart 2). The weak Q1 GDP at 0.2% will likely be followed by only a marginally better Q2 at 0.3%, and below what the BoE was expecting in its inflation report.

Chart 2: UK Economic Surprise Index
Source: Bloomberg as at 11 July 2017

On balance, the BoE has gained back some optionality. The market is now listening to its rhetoric and reacting to the macroeconomic data. In a speech on 20 June, MPC member Haldane complained about market complacency – but the market is no longer pricing the first rate hike in 2020 (a full hike is now priced for May 2018) so expectations appear to be much more reasonable.

I do believe that a removal of some of the emergency measures adopted in August 2016 is becoming more likely. But in the near term I don’t expect this to be a rate hike as the conditions set by the central bank are unlikely to be met. The economy remains weak and I am not hopeful that investment and exports will be strong enough to compensate for the weakness in consumption, while the chances of a smooth negotiation of Brexit are very slim. Instead, the BoE will leave the door open to a rate hike, but focus its efforts on the unwind of macro prudential measures, such as the countercyclical buffer and Term Funding Scheme.

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