UK rates will not rise for three years, says Ashburton International’s Hanson

Market response shows BoE’s options for stimulating growth are limited, according to Tristan Hanson, head of Asset Allocation at Ashburton International.

The Bank of England broke with tradition last week by introducing forward guidance to its policy framework. Specifically, Governor Carney announced an intention to maintain the current policy rate (0.5%) and maintain the stock of asset purchases at least until the unemployment rate has fallen to 7% (from 7.8% currently).

The threshold guidance will cease to apply if one of the three following conditions (the “knockouts”) fail to be met: (i) CPI inflation 18-24 months out is forecast to be below 2.5%; (ii) medium-term inflation expectations remain well anchored; and (iii) the FPC1 does not judge the stance of monetary policy to be a threat to financial stability (that cannot otherwise be contained). With the unemployment threshold not forecast to be breached until Q3 2016, the expectation is that the UK Bank rate will not rise for three years.

It was probably not Governor Carney’s intention that sterling should strengthen and UK gilt yields rise on the announcement, to say the least. However, this is exactly what happened. The “knockouts” were necessary to maintain consistency between forward guidance and the Bank’s inflation-fighting remit, but the market response demonstrates just how limited the Bank’s options are for stimulating growth, over and above what has already been done (namely low rates, QE and the Funding for Lending scheme).

Lingering negative sentiment towards sterling and the hope that Carney might ‘pull a rabbit out of the hat’ had weighed heavily on the currency in recent months. The immediate financial market reaction (both in terms of the exchange rate and the bond market) suggests there is nothing particularly revolutionary about the Bank’s new policy and the currency strengthened as the shorts closed out positions.

Given the recent strong UK data, investors may expect the unemployment rate to meet the 7% threshold earlier than 2016. Indeed the Bank’s Inflation Report shows an expected unemployment rate close to 7% by the start of 2015 (7.2% central forecast according to RBS economists). Meanwhile, CPI inflation is currently 2.8% and the Bank has consistently underestimated inflation while maintaining loose policy despite above-target inflation for 54 out of the previous 60 months. It is quite conceivable that UK rates could rise earlier than the implicit projection of 2016.

Forward guidance is not a game-changer for UK monetary policy although it should help anchor UK rate expectations and the bond market. This is desirable given the risk that stronger economic data or tighter US monetary policy could provoke an undesirable rise in UK bond yields. Overall, UK monetary policy has an easier bias than that of the Fed and this supports our modest preference for the US dollar at current levels: $1.55.

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