Forward guidance an explicit tool of monetary policy in the UK, says AXA’s Iggo

Chris Iggo, CIO Fixed Income, AXA Investment Managers, provides his outlook for the UK rate market in the light of forward guidance.

Forward guidance has become an explicit tool of monetary policy in the UK. The broadening of the policy options available to central bankers has become necessary because of the proximity of official interest rates to the zero bound. Interest rates have been reduced to as low as practically possible, central banks have expanded their balance sheets through asset purchases to keep long-term interest rates low, and now they are providing explicit guidance about future monetary policy options based on some evolution of the macro-economy.

In the case of the Bank of England, Mark Carney set out the case for forward guidance following the last MPC meeting and in the August Inflation Report. The bank rate will be left at 0.5% until the main headline measure of the UK unemployment rate falls to 7%. There are three ‘knock-outs’ that could potentially lead to a rise in interest rates before that – the MPC judges that inflation will be more than 0.5% above target over a 18-24 month period, medium term inflationary expectations become dislodged, or that the FPC judges that the current setting of monetary policy poses a threat to financial stability (i.e. asset price bubbles, excessive leverage). In the brief period of time that the market has had to consider forward guidance the response has been somewhat mixed, with market rates moving higher. However, one could make the case, on the basis of how the guidance has been presented, that rates will remain on hold for a long time to come.

Unemployment threshold

First consider the unemployment threshold. The current level of unemployment is 7.8%, so not too far away from the 7% threshold. However, it has been very close to the current level for the last 4 years. Unlike the case in the US, where there has been a genuine improvement in the labour market and a clear decline in the unemployment rate, the UK jobless rate has remained pretty flat. Unless this changes there is little chance of the 7% threshold being reached. Growth would need to be substantially stronger to generate a fall in the unemployment rate and, of course, stronger growth in itself would necessitate higher interest rates.

During the period from the mid-90s to 2008, the UK unemployment rate was below 7% but that was also a period during which real GDP growth averaged above 3.0%. That is substantially higher than the prospective growth rate of the economy in the next two years. So unless we get a growth shock or some structural change in the labour market that supports a lower unemployment rate, the 7% level may not be reached for some time and, on this measure, rates will remain at 0.5%.

Inflation rate

What about the knock-outs? Firstly, the MPC has never forecast that the inflation rate will be more than 0.5% above the target. If it did it would be essentially saying that it was not doing its job. So it is unlikely that this will happen unless the unemployment threshold has already been reached and this is generating upward pressure on wages. In my view then, this first know-out is a red-herring as the MPC is unlikely to forecast that it expects to miss its target when unemployment is still above 7% (and therefore the economy has lots of spare capacity) and would only do so if it collectively viewed that all that spare capacity had been used up, in which case unemployment would be below 7% and the MPC would have had to act on rates anyway.

Inflationary expectations

The second knock-out is a bit more ambiguous as it refers to medium term inflationary expectations becoming dislodged. Despite a pretty abysmal record in terms of actual inflation performance relative to the MPC target, medium term inflation expectations have remained quite stable in the UK – either based on market expectations (break-even inflation rates) or surveys of consumer inflation expectations. Again, for inflation expectations to become seriously higher, growth would need to be stronger, unemployment lower and wages rising. The one risk I do see here is based on the possibility of current inflation going through one of its periodic increases.

Over the last decade the MPC’s response to these inflationary episodes has been to look-through them and explain them away on the basis of one-off shocks (weak sterling, oil prices, VAT increases etc.). However, there is always the risk that a rise in spot inflation can dislodge medium term inflationary expectations particularly if economic agents take into account the failure of the MPC to meet its inflation targets in the past.

It is all well and good for the MPC to promise that inflation will remain close to target in the future (as it has done at every Inflation Report since 1997) but it cannot compensate households for past inflationary mistakes and the erosion of real income that has occurred as a result. However, even with this risk, it is difficult in practical terms to see how the MPC would make a judgement about inflationary expectations. In practice some monetary policy response would be forced by increased market volatility reflecting a lack of confidence in policy – for example, a sharp decline in the value of sterling or a sharp rise in long term interest rates.

Macro-prudential factors

The third knock-out is a sign that macro-prudential factors are more integrated into monetary policy. A prolonged period of low interest rates could lead to some asset price bubble or an increase in leverage in the private sector. The FPC could them judge this to be a threat to overall financial stability and thus advise the MPC that a change in policy was required. Sounds sensible. However, can we really see this happening in practice? What data will the FPC use to make such a judgement? The obvious area is the housing market. A rapid increase in house prices and household leverage could provoke a judgement by the FPC and an increase in rates by the MPC. I’m just not sure how quickly such a response would come about and what threshold levels of asset price inflation and leverage would be identified as posing a systemic threat. Arguably policy should be tightened now given the anecdotal information about current trends in the housing market.

Carney was hired with the strict mandate of introducing forward guidance as a part of the Bank of England’s monetary policy toolbox. He has introduced it and the MPC will back it up with verbal intervention against any unjustified rise in market interest rate expectations. It would be a massive loss of credibility if the MPC backed off from forward guidance soon after it was introduced, even if the current run of better economic data continues through the second half of the year. The message is clear, policy rates will remain at 0.5% for as long as possible and the MPC will do all it can to prevent the market pricing in higher rates before there is a substantial improvement in GDP growth and thus a real prospect of the unemployment rate falling below 7%. The sub-message is borrow now because rates are going to remain extremely low.

Impact on bond markets

For the bond market then we see two trends. Short rates remain low and investors will be tempted to buy into short gilts or receive in the short end of the swap market on the back of any rise in market rates. However, the longer end of the gilt curve is going to be more impacted by global trends and, in particular, what happens to the US Treasury market as the Fed gets closer to tapering of QE. The unemployment rate in the US could get down to 6.5% a lot more quickly than the UK rate gets to 7% and therefore upward pressure on US rates will remain more intense than in the UK or Europe. But because of the correlations, gilt and bund yields will rise as US Treasury yields rise above 3% in the next 6-12 months. That means a steeper UK yield curve. For choice, I think it also means a lower sterling/dollar exchange rate and a move below $1.50 should not be ruled out in the last 3 months of the year.

Two ways that policy will be tightened

Ultimately I see two ways that policy will be tightened. The first is the way the MPC would like it. Growth strengthens, inflation remains in check and the spare capacity in the economy is gradually eroded. Such a scenario is still likely to play out over a fairly long time horizon given the deleveraging that remains a drag on growth in the public and private sector, but is one that supports the continued solid performance of equities, credit and real estate.

What are we talking about here? Maybe the first rate hike in 2015 and rates at 3.0% not until 2017? The alternative is that the MPC is forced to raise rates to re-establish credibility in the face of higher global bond yields, rising inflation, a booming UK housing market or a currency shock. My preferred way to play either is by being short duration in fixed income portfolios and long inflation protection on the view that given that the knock-outs are not very water tight in my view, inflation can rise before the MPC acts and a 3.5% 10-year break even inflation rate looks consistent with the current policy framework (current level 3.04%).

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