By Anthony Harrington
Federal Reserve Chairman Ben Bernanke has done much to popularize the idea that providing "forward guidance" on interest rates is a powerful tool in a central bank's armory. The argument he introduced is that, without actually adding more assets to its balance sheet or printing a single note, a central bank can strongly push public and institutional opinion in the "right" direction (i.e. the direction desired by the central bank), simply by giving plain, straightforward long-term guidance on interest rates. One of the biggest fears the market has now, after years of quantitative easing (QE) and low interest rates, is that rates will rise unexpectedly and overturn the "loose for longer" environment that has pushed stock markets to record highs.
Bernanke, as we now know, stumbled and dropped the baton on forward guidance at the Federal Open Market Committee meeting in September. The world, following his “clear guidance” expected him to go one way, and lo, he went the other. That does not enhance his reputation for clear forward guidance. It’s called wrong footing the markets and it will be a while before he is forgiven. Which brings us to the new governor of the Bank of England (BoE), Mark Carney. Like Bernanke, he has tried to lay potential market jitters to rest by announcing loudly and publicly that the BoE has no intention of raising rates in the foreseeable future. In theory, this should calm markets. However, when Carney tried to follow in Bernanke's pre-September footsteps in a press conference on 9 August, he rapidly discovered that markets can look through central bank wheezes and make their own judgments about how trustworthy such forward looking guidance is likely to be.
The essence of Carney's monetary policy guidance speech was that the BoE would keep rates at 0.5% not just until the economy picks up, but until the jobless figure falls below 7%. Carney went on to add that he did not anticipate the unemployment rate falling to the target level until 2016 at the earliest, which seemed to promise three years of stable, low interest rates. This kind of blanket promise extending deep into the future is new territory for the BoE, which traditionally preferred to keep its options open.
However, as senior international economist Jeremy Lawson and Standard Life Investments Director Philip Laing note in a recent widely publicized briefing, while Carney's move was bold and innovative for the BoE, there were at least two things working against Carney achieving his goal of providing the markets with certainty. First, while he did indeed provide explicit and clear long-term forward guidance, he hedged enough to give the BoE plenty of wriggle room if the economy, and of course inflation, decide to pick up the pace. There were rather too many caveats and conditions surrounding the guidance. Second, there are already some signs that things could indeed pick up rather sharply - which means that we're not really much clearer about the path of interest rates than we were before the speech. This was certainly not the intention of the new Governor.
Specifically, Carney gave himself and the BoE three "get-out-of-jail-free" cards. If the BoE comes to the conclusion that inflation is likely to exceed 2.5% in 18 to 24 months time, it might act to raise rates. If inflation expectations become muddled and out of control it will act, and if there is evidence that the "loose for longer" policy - which by many have been dubbed "financial repression" - looks like undermining financial stability, the bank will act. Since no one could put their hand on their heart and say with utmost confidence that they "know" that inflation will not exceed 2.5% in 18-24 months time, the 3-year grace period Carney appears to be offering to those who love low rates (which certainly does not include savers) comes down to nothing more than a pious intention. You get some Brownie points for good intentions, but not many. The markets much prefer certainties.
The two Standard Life authors take these caveats that Carney bolted on to his promise of low rates to 2016 as a clear sign that the new Governor is being hemmed about by the hawks on the Monetary Policy Committee. They say:
"This flexibility is a nod to the more hawkish members of the MPC who are less convinced of the merits of forward guidance and more worried about inflation risk."
What it comes down to is that Carney has done his best to flag up the BoE's preference for low interest rates for the foreseeable future, and the markets have listened and then done their own thing. Where Carney's forward guidance might help, the authors suggest, is in protecting the U.K. against a tide of rising interest rates as and when the Federal Reserve starts its policy of tapering off QE. If Carney succeeds here, then the dollar will rise as the U.S. economy grows in strength and sterling will crash, paradoxically improving both the U.K.'s debt position and its exports. All kinds of forces will then be set in motion including a potential carry trade borrowing low interest sterling to buy dollar assets. Fun times ahead!