By David Hooker
Since the financial crisis, central banks have cut interest rates to near zero levels, leveraged their balance sheets through quantitative easing and printed money. Governments across the developed world have record levels of debt. These unconventional measures have worked to a degree; in the US and UK in particular there are clear signs of a cyclical economic upturn.
However, what investors and policymakers do not yet know is whether there will also be unintended consequences from this unprecedented monetary experiment, including a rise in inflation. These extraordinary measures now seem likely to be accompanied by a change in the UK monetary policy regime, adding further to uncertainty.
There have been many different policy frameworks: the gold standard, money supply and exchange rate targeting to name but a few. We have already seen a subtle change to the UK framework. In the pre-crisis years the Bank of England’s Monetary Policy Committee (MPC) appeared to have a policy reaction function to its inflation forecasts. If, on the Bank’s forecasts, the probability of inflation being above target in two years’ time, the MPC tightened policy. Similarly, if the probability of an inflation undershoot was high, then policy would be loosened.
When Mark Carney became governor of the Bank of England, he introduced forward guidance, promising that the MPC would not consider raising interest rates until unemployment had fallen to 7% or below. By February this year, with unemployment heading for 7% much earlier than expected, the focus shifted to a wider range of economic variables including the output gap. Six months later, with the MPC revising down their forecast of the amount of spare capacity in the economy, the focus switched to real wages. This change in focus led one Labour MP to claim that the Bank of England was acting like an “unreliable boyfriend” in hints over interest rate rises.
The question for investors is what factors are shaping policy for the governor and the eight other members of the MPC? If inflation targeting is coming to the end of the road, what will replace it? Looking at real economic variables such as the unemployment rate would not necessarily be a bad benchmark, just a very different mandate to what investors have been used to over the past 20 years. And that is what should be concerning bondholders: how much in real terms will their investments be worth in the future? There is a possibility that the UK could end up with a higher rate of inflation in the future simply because it is no longer the sole focus for policymakers.
Investors are also not currently focused on the possible long-term inflation risks. With supermarket price wars, falling commodity prices and the eurozone teetering on the brink of deflation, the debate is around how low inflation could be in the future. But despite this deflationary backdrop, UK core CPI printed 1.9% in August, close to the Bank’s 2% target.
Looking at market pricing, the consensus expectation is that two years from now the Bank of England is more likely than not going to undershoot its inflation target. Even 10 years out, the market only just expects the Bank of England to hit its inflation target. Financial markets appear priced for policy perfection, which given the scale of the economic crisis and policy response is remarkable. Investors appear happy to price no risk premium into policy error. This is overly complacent. Inflation is priced through expectations and by the time prices start rising faster than markets expect, the best time to hedge has already passed.
David Hooker is a senior inflation-linked portfolio manager at Insight Investment.
Comments