Now that we have confirmation of monetary policy divergence from the UK’s two largest trade partners, the eurozone and the U.S, the question of UK monetary policy becomes ever more interesting. 
On the one hand the economy is continuing to perform well – growth is above trend, employment is at a record high, the banking system has been restructured and public sector borrowing is moving back to more manageable levels.
However, lingering doubts remain about the path of inflation – the headline rate is hovering around zero, and underlying inflationary pressure still looks relatively weak.
Given that monetary policy acts with a lag, will the dominant influence at the MPC be skewed to slowing the economy as the output gap is eliminated, or will concerns over the persistently low level of inflation win out?
The arguments for tighter monetary policy over 2016 are familiar ones. The domestic economy continues to perform well. We expect above-trend growth in the UK of 2-2.5 per cent, driven in large part by resilient consumer spending and business investment.
That in turn should spur further employment growth, and with the unemployment rate already just 5.1 per cent we should expect some further upward movement in wages as the pool of available labour shrinks. The last time that the unemployment rate was at these levels, wage growth was two percentage points higher than the current 2.0 per cent annual increase.
For example, if we take the period from Q1 2001 (when the average earnings series started) to Q1 2008 the unemployment rate averaged 5.1 per cent and earnings averaged 4.3 per cent.
That would suggest that in time we should see stronger wage growth than the current 2.0 per cent, and, in fact, the BOE’s forecasts for wage growth for 2016 and 2017 are 3.75 per cent and 4 per cent , respectively. If that happens we should see inflation rise.
Source: Office for National Statistics
So what about the risks that inflation continues to undershoot?
When looking at inflationary pressures, given that food and energy prices are set internationally, it is often useful to look at inflation excluding these two sectors to get a sense of how much domestically generated inflation there is in the economy.
Performance of index over 3yrs
Source: FE Analytics
Here the news is still, at best, mixed. The consumer price index (CPI) excluding food and energy prices is just 1.4 per cent. Additionally, the recent levelling off in wage growth presents the risk that they do not rise as expected, and that the previous relationship between the unemployment rate and wage growth no longer holds.
In this case we could see subpar inflation for even longer than we expect. 
So where does this leave the MPC, and what are the risks as we move through 2016? In the case of the BOE’s forecasts, it sees headline inflation rising to 1 per cent by the end of 2016 and 2 per cent by the end of 2017.
Our own forecasts are currently in line with the BOE. The first thing to note is that the MPC is tasked with delivering 2 per cent CPI over the medium term, with a tolerance band of 1 per cent –3 per cent.
For each quarter that the CPI deviates outside of the 1-3 per cent range, such as now, the BOE Governor Mark Carney must write an open letter to the Chancellor of the Exchequer George Osborne detailing the causes of the deviation and the route by which inflation will return to target.
This is important, because at present the Governor remains in letter-writing mode, and yet the BOE’s own forecast is that CPI will return to 2 per cent by the end of 2017 and continue rising gently thereafter.
So in theory, given the lags between a change in monetary policy and changes in inflation, above-target CPI early in 2018 should encourage the MPC to tighten as early as the first half of 2016. However, it is also likely that for much of 2016, we will see the Governor continuing to write letters to the Chancellor explaining why spot inflation is so low.
Given that inflation has persistently surprised on the low side, it would be a brave committee that hikes rates whilst the Governor is still writing letters explaining the current inflation undershoot.
That suggests that the first minimum criteria to be met before any monetary policy tightening is a headline inflation rate back above 1 per cent, and the BOE does not see this condition as being met until late 2016.
Alongside this, the MPC will also want to see some stronger underlying price pressures, preferably via the core inflation rate going up, and some return of rising wage growth.
In effect the MPC will want to see higher actual inflation and wage growth before being comfortable with any monetary tightening. The challenges facing the MPC are akin to those of the ECB – namely a single target (inflation), which is still stubbornly low.
On the other hand the MPC faces the same challenge as the U.S. Federal Reserve, which is that while current inflation is low, given the strength of the economy and the leads and lags involved in tightening, now would be a good time to consider tightening.
That is why we expect the MPC to sit on the sideline until late 2016 at the earliest, when they will have more data and the picture becomes clearer – in effect taking the middle ground between the
ECB and the Fed
When considering the implications for markets and the risks around MPC action, there are two data points worth noting.
The first is that current market pricing is for the MPC to start to raise interest rates in Q1 2017, with an additional 100 bps of hikes over the following three years. That would leave Bank Rate at 1.75 per cent by 2020.
Whilst the cumulative cycle seems plausible, the start date seems late.
That suggests that if we do see some upward movement in core inflation and wages, the short end of the UK market is vulnerable.
At present we would rather reflect this in portfolios as a yield curve exposure rather than an outright underweight given the likely cumulative hiking cycle and the steepness of the curve.
As ever there are risks around any central expectation. In particular the second half of 2016 is likely to see the UK Referendum on membership in the EU. At present the polling suggests a close vote, and whilst our central expectation is for a vote to remain in the EU, there is clearly a significant chance that the vote goes the other way.
Given the uncertainty that would ensue, it would be hard to see the MPC embark on a tightening cycle at or around the referendum, especially if the vote is to leave.
The “risk premium” surrounding the vote and the stubbornly low level of inflation explain the low level of UK government bond yields across the curve.
However, until we have greater clarity it seems unlikely that we will see a major revision to the overall level of the market. Just as with the stance of monetary policy, bond yields sit somewhere between U.S. “risk-free rates” and eurozone “risk-free rates”.
Performance of indices over 1yr
Source: FE Analytics
In effect both the market and the MPC are caught between two opposing forces – econometric models suggesting that the downward pressure on inflation will abate in time, in which the prudent policy response would be a gradual tightening of monetary conditions, and the hard data suggesting that prior relationships between growth and inflation may be less robust, which would warrant caution on a policy tightening cycle.
Fortunately this set of circumstances affords the MPC time to see how the economy evolves before acting.
Our expectation is still that in due course we will see higher UK interest rates, but the countervailing forces should not be dismissed.
Yield curve positions favouring intermediate bonds should deliver better risk-adjusted returns than outright duration in this environment, whilst low interest rates and resilient growth should remain supportive of high quality credit.
Michael Amey is manager of the Pimco GIS UK Low Duration and Pimco GIS UK Sterling Long Average Duration funds. All the views expressed above are his own and shouldn’t be taken as investment advice.