Forward Guidance Is Back at the Bank of England

The last few weeks have seen the UK deliver its fair share of surprises. Most notable was the surprise Conservative majority at the recent UK general election on 7 May, against widespread expectations of another coalition government. However, this has not been the only surprise of recent weeks: The Monetary Policy Committee (MPC) at the Bank of England (BOE) has also unexpectedly re-entered the forward guidance debate, by noting in the minutes to its April meeting that the markets’ expected pace of interest rate hikes – once the first is done – was “exceptionally slow.” Indeed, the MPC in its minutes even went as far as to quantify “exceptionally slow” as “around three basis points per quarter.” My immediate thought on reading those minutes was this: Yes, three basis points (bps) per quarter is exceptionally slow, but where did this number come from? The MPC comment likely relates to the time taken for official rates to rise by 100 bps after the initial 25 bps hike. Given that this would put the official short rate at 1.75% and 10-year gilts closed at 1.57% the day before the minutes were released, it is understandable that implied levels mean it would take many years to get to 1.75%. In effect, the comment was related to guiding up five- and 10-year yields. To that end, at the time of writing, the MPC has certainly succeeded.

Completing the recent policy chronology has been the BOE’s May 2015 Quarterly Inflation Report, which in effect validated the comments in the MPC minutes, rather than aim for additional (upwards) forward guidance. So where does that leave the outlook for the UK? Is it reasonable to expect rates to start to rise in mid-2016, and is the yield curve still too flat?

The current economic landscape
Let us begin with the current set of economic conditions. The headline consumer price index (CPI) in the UK is now -0.1%, the core rate (excluding the more volatile food and energy component) is 0.8% (according to the Office for National Statistics, 19 May 2015) and the BOE’s medium-term target remains 2%. As BOE Governor Mark Carney explained at the 13 May press conference alongside the publication of the Quarterly Inflation Report, around 75% of the 2% undershoot on the headline CPI is due to lower food and energy prices and lower import prices as a result of recent sterling strength (according to the BOE Governor’s open letter to the Chancellor of the Exchequer, 13 May 2015). Dr. Carney expects these price shifts to be transitory; and as growth is currently running above trend, the combination of these factors fading and the elimination of the output gap is expected to be sufficient to push the CPI back to 2% by mid-2017, rising gently further thereafter (see Figure 1). In central-bank-speak, this is intended as a fairly clear statement that policy can be expected to be tightened over the next couple of years.

What role does a strong pound play?
The striking aspect of the CPI projections is the speed with which CPI is expected to bounce back to the 2% target. This would require not only the current downward pressure on inflation from sterling strength to fade but also higher domestically generated inflation. In that context, it is important to note that the last time sterling rose strongly was from mid-1995 to early 1998, when sterling rose by 28% on a trade-weighted basis. However, CPI only hit a low a year later, and barely moved for a subsequent five years. Clearly, there were other factors at work during that period, most notably the effect of globalisation, but the persistence of low inflation despite the domestic economy being strong is striking. This would suggest that a sharp pass-through of the current 14% rise in sterling may prove optimistic.

How important is healthy wage growth?
Looking at domestically generated inflation, the key remains the UK labour market. Rising nominal wages are needed to support the recovery, to put upward pressure on domestically generated inflation and to provide the consumer with enough financial resilience to withstand a set of interest rate rises. As the Conservative Party were at pains to highlight during the election campaign, the labour market has done a very good job of creating employment, with over two million jobs added since the financial crisis. The unemployment rate has fallen from a peak of 8.4% in 2011 to 5.5% today (according the Office for National Statistics, 13 May 2015). The flip side of this jobs bonanza has been weak productivity growth and weak wage growth. Looking at Figure 2, nominal earnings growth has been stuck between zero and 2% for the better part of five years.

The persistent weakness in wages has been one of the longer-term surprises of the UK recovery, and as yet it does not seem to have been solved. Most estimates place the level of unemployment consistent with stable inflation in the UK at 5%; given that the unemployment rate has fallen to 5.5%, we should be starting to see some movement up in wages from what are still relatively depressed levels. Getting out one’s magnifying glass, there is some hope, but one has to peer very closely at the figures. The headline earnings number is an average of the last three months’ worth of data, but stripping down to the last single month, we saw wage growth rise by 3.3%, which may suggest we are finally seeing some upward pressure on wages. It is, however, very early to make such a statement given that we have seen spikes in wage growth before (which is precisely why the headline series uses the three-month average).

Putting this all together, the risks around the BOE’s medium-term CPI forecast are skewed to the downside. This is also before we start to think about the political cycle, and the prospect for getting more of the fiscal tightening done earlier in this Parliament given the current strength of the UK economy. UK Parliamentary terms last for five years, and the deficit ended the last fiscal year at 4.8% of GDP; so getting the pain out of the way early would seem to make political sense. That would act to dampen domestically generated inflation.

Managing expectations
Given all of this, why then have the MPC and Dr. Carney been so keen to guide market interest rates higher? There appear to be a number of reasons – some domestic and some international. Part of the rationale for guiding interest rates higher is to reinforce the message that the MPC strongly believes that any downward effects on inflation are transitory. This is of particular importance given comments from Dr. Carney’s colleague, BOE Chief Economist Andy Haldane, who stated that he was watching the UK inflation data “like a dove” and that the next policy move is equally likely to be in either direction. In effect, the MPC is keen to avoid any perception that the UK is at risk of persistently low inflation, or indeed deflation.

It is also the case that UK interest rates tend to correlate strongly with U.S. interest rates. Notwithstanding the recent soft patch of U.S. economic data, it remains likely that the U.S. Federal Reserve (the Fed) will raise interest rates at some point over the second half of 2015. As this would be the first Fed hike for nine years, there is likely to be some volatility around the event. Part of the rationale for the MPC rhetoric is to put a greater risk premium in the UK bond market ahead of the Fed’s anticipated rate hike.

Keep the faith
In the final analysis, it is very clear that the MPC remains a keen proponent of forward guidance. However, unlike previous episodes, the current round of forward guidance is specifically designed to avoid gilt yields becoming too low ahead of the Fed, and potentially the BOE, finally starting to move interest rates higher. At present, it looks like the Fed is materially closer to this moment than the MPC.

The UK economy tends to have a greater sensitivity to currency strength and the UK faces further fiscal tightening. Meanwhile, the nature of the UK mortgage market, which is predominantly floating rate or short-term two- or five-year fixed rate mortgages, would imply that a hike in the official interest rate would have a more immediate impact on consumers, many of whom will see higher mortgage rates within a matter of months. Given the low level of nominal wage growth, and the fact that real wage growth has been negative for the vast majority of the last five years, there is a good argument for caution before tightening UK monetary policy.

Taken together with the likelihood that CPI could well remain below the 2% target throughout 2016 and possibly 2017, our analysis suggests that the first UK interest rate hike may not occur until mid-2016, at the earliest. If that is the case, then the current bout of forward guidance is more about making sure that the market “keeps the faith” that the next move will be up, rather than any genuine expectation of a policy tightening in the UK anytime soon. That would also suggest that a further sharp steepening of the front end of the yield curve may be a while off yet.