By Darren Williams
Mark Carney has had an easy ride since taking the helm at the Bank of England on July 1 last year. However, we suspect that the hard work starts now if Carney is to sustain the recovery and guard against medium-term risks to economic and financial stability. Fortunately, he is showing welcome signs of pragmatism.
When Carney took over from Sir Mervyn King, the previous governor, the UK economy was growing at an annual rate of just 0.3%. Four robust quarters later, it is growing at 3.1%—the fastest rate of expansion since before the crisis.
Meanwhile, almost 800,000 jobs have been created (the most since the late 1980s) and the unemployment rate has fallen from 7.8% to 6.6%. And since Carney came to office, inflation has fallen from 2.7% to 1.5%; back below target for the first time since 2009.
The key to the recovery, in our view, is that the highly expansionary monetary policy implemented under King has finally started to gain traction.
And while it may not seem obvious, the European Central Bank (ECB) has helped too. By stabilising sovereign debt markets in the euro area, the ECB has helped reduce funding costs for UK banks, allowing mortgage rate to fall to record lows.
Testing times ahead
Carney faces two main challenges in coming months: when to raise interest rates and what to do about a rampant housing market.
The Bank will soon be given new powers to take the steam out of housing, and will surely use them, but gauging the right time to start raising rates is more difficult.
If the Bank raises rates too early, it risks derailing the recovery. But if it raises them too late, it risks fostering more imbalances in the economy – the current account deficit is already at its widest since the late 1980s.
So far, the Bank’s strategy has been based on the belief that there is sufficient spare capacity in the economy to let it grow rapidly without endangering price stability. But that’s a dangerous game to play when spare capacity isn’t directly measurable.
That’s why we have thought for some time that the Bank’s focus would eventually switch towards the actual growth rate of the economy—which is directly measurable.
Carney’s Mansion House speech last week was important. Not only did he say that interest rates could begin to rise “sooner than markets currently expect”. He also said that one of the key challenges “in deciding when to begin normalising policy is that actual output can be observed but potential supply cannot”.
Dove, hawk or pragmatist?
Importantly, the more hawkish tone of Carney’s speech suggests that he might not be the arch “dove” that everybody seems to think he is, but someone who adapts his views as the evidence before him changes. In other words, Carney might not be a hawk or a dove but a pragmatist.
If so, this would be welcome news. With the recovery looking more secure, asset prices rising strongly and imbalances starting to build, we think the withdrawal of some monetary accommodation will soon be necessary. As the Bank’s governor, Carney should be leading, not resisting, this process.
Darren Williams is senior European economist at Alliance Bernstein
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