By Chris Iggo
I have never been one for watching TV soap operas, not since my student days at any rate, and if I did I’d be more ‘Coronation Street’ than ‘Eastenders’. But following central banks is similar to those regular doses of TV (un)reality.
The casts change over time, episodes are punctuated by hysterical reactions to the things people do and say, observers speculate endlessly about what will happen next and the whole thing is both a reflection and parody of real life.
While there are various story lines the plot essentially never changes. And we are just experiencing the start of a new story line for the Bank of England. At the presentation of the latest Inflation Report, Mark Carney essentially abandoned the forward guidance framework he and his staff and painstakingly constructed last August. The dismantling of Forward Guidance V.1 came before one of the self-constructed knock-outs was triggered – namely the decline in the Labour Force measure of unemployment to below 7%.
The last print was an unemployment rate of 7.1% and it is certainly going to be the case that it falls below 7% long before the Monetary Policy Committee (MPC) thinks the UK economy should be subject to an increase in interest rates. Just as the excitement might build when a soap character is about to make public some adulterous secret – only to be told the affair is over – the UK money markets were in danger of seeing that 7% level breached in the next month or two, bringing with it the potential for a significant rise in rate expectations – only for Carney to consign that single measure to the dustbin of failed central banking initiatives. Collective sighs of relief, rates can stay lower for longer, roll the credits and the dramatic theme music.
Bye bye forward guidance
The bank has removed its reliance on simple thresholds for determining the next phase of monetary policy. It now says that it will look at a broader range of indictors to assess the spare capacity in the UK economy and there is no longer any explicit time or state dependency in the conduct of monetary policy going forward.
We are back to the old days. What will drive UK monetary policy now is the collective assessment of how much spare capacity there is – relying on more indicators than simply the unemployment rate itself. In the Inflation Report the bank estimates that the level of spare capacity is around 1%-1.5% of GDP and that there is still slack in the labour market given that its guess of the natural rate of unemployment is somewhere between 6% and 6.5% and its additional assessment that some workers are willing to work longer hours.
While there is spare capacity in the economy, the risks to the inflation outlook are to the downside. Certainly the recent performance of inflation gives the bank some wiggle room, allowing rates to be kept low for longer than would have been the case if the knock-out features of Forward Guidance V.1 had been taken at face value.
Back to the future
My view is that policy has reverted to its pre-crisis mode of assessing a broad range of economic developments and making judgements about the likelihood of inflation being in the target range over the medium term. This is what the MPC was set up to do. One telling box in the Inflation Report (page 9) illustrates this. I quote, “The actual path Bank Rate will follow over the next few years is, however, uncertain and will depend on economic circumstances.
Bank Rate may rise more slowly than expected, and increases…may be reversed, if economic headwinds intensify or the recovery falters. Similarly, Bank Rate may be increased more rapidly than anticipated if economic developments raise the outlook for inflation significantly”. In soap opera parlance, if growth’s strong mate, we raise rates. If not, we won’t.
Chris Iggo is CIO, fixed income at Axa Investment Managers
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