Mark Carney, the Bank of England governor, has a simple message on interest rates, which is that they will stay low until the recovery is well established. Unfortunately for him, the financial markets are not as receptive to that message as he hoped. He will keep battling to convince them.
It emerged the other day that George Clooney, the Hollywood actor, helps fund a spy satellite to monitor activity on the ground in Sudan, and keep an eye out for any atrocities. It may be that Mark Carney, the new Bank of England governor, said to be a George Clooney lookalike, will have to resort to similar means to check whether his policy message is getting over in Britain. So far, despite his best efforts, it is proving to be a struggle.
The message from the new governor, recruited from his native Canada after a huge effort by George Osborne, is a simple one. As he put it in his first big speech, delivered in Nottingham in late August: ‘Three weeks ago, the Monetary Policy Committee (MPC) did something it has never done before: we gave clear, quantitative guidance about the future path of monetary policy. Specifically, we announced that we do not intend to raise the bank rate at least until the unemployment rate falls to 7%, provided there are no material threats to either price or financial stability ...
‘Our forward guidance provides you with certainty that interest rates will not rise too soon. Exactly how long they stay low will depend on the progress of the recovery and in particular how quickly unemployment comes down. What matters is that rates won’t go up until jobs and incomes are really growing. The knowledge that interest rates will stay low until the recovery is well established should give greater confidence to households to spend responsibly and businesses to invest wisely.’
It is a straightforward message. The new governor is saying to businesses and households that they need not fear higher rates until the economy has achieved what he calls ‘escape velocity’ from the recession, that it is strong enough not to risk stalling. Perhaps it would have been more straightforward if the new governor had set out the Bank’s interest rate intentions in what is known in the jargon as a ‘time contingent’ way, in other words rates staying where they are for a fixed time, say the next three years.
As it is, people and businesses are required to join up the dots to get to a similar result. Carney’s forward guidance is ‘state contingent’, rather than ‘time contingent’; it depends on the state of the economy. But the result is similar. The Bank’s Monetary Policy Committee will not begin thinking of raising the bank rate from its present 0.5% until the unemployment rate is 7%. It does not expect that to happen over the next three years. Therefore, rates look stuck until 2016, possibly later.
Why then has the new governor had such difficulty convincing financial markets, and some outside the markets, of this? The launch of his forward guidance has come at a time of rare strength for the economy. The recovery is taking hold. GDP rose 0.3% in the first quarter, 0.7% in the second and may be stronger in the third. Economists are busy revising growth forecasts up and unemployment predictions down.
So their view is that it will not take as long as 2016 for unemployment to drop from its current 7.8%. It may happen no later than 2015. The Bank will not have to raise rates then but will be under pressure to do so. That is why markets are pricing in rate rises before 2016, despite the governor’s assurances.
As it happens, I think Carney is on strong ground. In the past year, employment has grown by 300,000, but the unemployment rate has dropped by only 0.2%. At this rate, it will take time to get down to that 7% threshold. But the markets will take some convincing.
Disputes about unemployment are not the only problem clouding the Carney message. When he detailed the policy at the launch of the Bank’s August inflation report, he also set out three ‘knockouts’ or overrides when interest rates could be raised, even if unemployment remained well above 7%. So the Bank might raise rates if it found itself predicting inflation of more than 2.5% in 18–24 months’ time (the inflation target is 2%). Or it could do so if inflation expectations in the markets, and among businesses and individuals, are no longer ‘well anchored’. Or, third, if its own financial policy committee decides low interest rates have become a threat to financial stability; for example, if borrowing got too strong.
These ‘knockouts’ do not look too troublesome. The last two, for example, are judgments by the Bank itself. And, while inflation has regularly been above 2.5% in recent years, the Bank has always predicted that it will return to the 2% target. There is no reason to think the Bank is suddenly going to start predicting above-target inflation.
In the markets, however, and among independent economists such as those on the Institute of Economic Affairs’ ‘shadow’ monetary policy committee, there is unease. Inflation has been higher than it should have been. If it continues to be above the official target, there could be a loss of confidence in a Bank committed to keeping interest rates low. In such circumstances, sterling could fall and there would be a sell-off in UK government bonds (gilts). The Bank might have no option but to raise rates. Events would scupper the Carney strategy.
This possibility aside, does it matter that the markets think interest rates will rise sooner than the new governor wants? After all, he and his MPC colleagues make the decisions, not the markets. The trouble is it does matter. Rising market rates affect the cost of borrowing in the economy even if the bank rate stays unchanged. This is a battle Carney needs to win. So far he is struggling to do so.
