Schroders’ European Economist, Azad Zangana, comments on yesterday’s Bank of England Inflation Report:
The new governor of the Bank of England (BoE), Mark Carney, had his debut Inflation Report press conference yesterday, and was quick to unveil the biggest change to the BoE’s communication policy since it was made independent in 1997. In addition to the BoE’s usual assessment of growth and inflation pressures, the Bank of England has introduced forward guidance – a policy that Carney had introduced in his former role as the governor of the Bank of Canada, and one that has been implemented by the US Federal Reserve since.
Carney announced that interest rates would not be increased, and the stock of holdings of gilts (also known as quantitative easing) would not be reduced before the rate of unemployment falls to a threshold of 7% (from its current rate of 7.8%). The governor stressed that the 7% threshold is not a target, but a reference point in which the Monetary Policy Committee (MPC) would reconsider the appropriateness of interest rates.
In an attempt to safeguards the BoE reputation as an inflation fighter, three ‘knock-out’ conditions have been added that would override the unemployment threshold:
1. If the outlook for inflation on an 18-24 month time horizon is judged to be more likely than not to be higher than 2.5%;
2. Inflation expectations in the medium term become unanchored;
3. The Financial Policy Committee (FPC) considers monetary policy to not be compatible with a stable financial system (after the FPC has exhausted the tools at its disposal).
If any of the three ‘knock-outs’ are triggered before the 7% unemployment threshold is met, then forward guidance would be put aside, and policy tightening would then be considered, but not necessarily implemented.
In order to provide more details, the BoE has now introduced an unemployment forecast to help explain how far the MPC is from raising interest rates. The MPC forecasts the probability of meeting the 7% unemployment threshold to be below 50% until the middle of 2016. Reading between the lines – the Bank of England does not expect to ‘reconsider’ the rate of interest before the middle of 2016, or even the start of 2017.
Incidentally, the BoE substantially upgraded its outlook for GDP growth on the back of stronger readings from private business surveys, increased activity in the housing market and the improved performance amongst retailers. As Carney stated in his opening statement: “A renewed recovery is now underway in the United Kingdom, and it appears to be broadening.” The outlook for inflation was left broadly unchanged, suggesting that the Bank believes supply to be growing at a similar pace to demand.
Overall, while the introduction of forward guidance was widely expected, the choice of a 7% unemployment target is a little more hawkish than expected, but the BoE’s assessment on when that threshold may be met is fairly dovish. Interestingly, the early market reaction of falling money market interest rates has now reversed, and we may end the day with higher market interest rates after forward guidance. While assessing the impact of a change in policy is always dangerous after just one day, if higher interest rates persist for longer without a much more positive macro outlook (more positive than the Bank’s already optimistic outlook), then the introduction of forward guidance will have failed.
It is worth noting that the BoE decided to change the way it presented its growth forecast this quarter because of the introduction of forward guidance. The Inflation Report usually contains a growth forecast predicated on market interest rates, and a forecast using constant interest rates. In recent years, the market interest rates have usually shown some interest rate rise, which has meant that the growth forecast was lower than that of the one using the constant rate. The August Inflation Report does not include a GDP forecast based on market rates as the MPC expects/hopes the market rate to converge with the constant rate. Therefore, if market interest rates do not fall to reflect the BoE’s communication, then this would be negative for the Bank of England’s forecast growth forecast. This may lead the committee to react by punishing market participants by lowering interest rates further, or restarting quantitative easing.
As a result of today’s announcement, we are pushing out the first interest rate rise in our forecast from the middle of 2015 to the start of 2017 - a further blow to savers. In our view, the ‘knock-out’ conditions are very weak and are unlikely to be triggered before the 7% threshold is reached. We also do not expect an instant hike in interest rates when the threshold is reached, as questions over the UK’s poor productivity growth are likely to persist
With regards to quantitative easing, we are no longer explicitly forecasting an increase over this year or next, however, we cannot rule out the Bank of England restarting its programme, especially if money market interest rates do not fall. Finally, based on the change in our interest rates forecast, we now see greater upside risk to both GDP growth and consumer price inflation further out. The MPC may eventually come to see those risks, but in the absence of lower unemployment and much higher real wage growth, the BoE is unlikely to react for many more years.
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