RMG Investment Bulletins
With great expectation (within the media at least) Mark Carney the new Governor at the Bank of England revealed his new strategy this week. Mark Carney is viewed by many as the pre-eminent central banker of the day and his boss at the UK Treasury will certainly be hoping that he can help lift the UK economy into escape velocity. So, what do we make of his new strategy?
The first point to make is that central bankers really only have four tools in their policy set; interest rates, liquidity (granted against high quality collateral), quantitative easing and verbal intervention. With interest rates at the zero lower boundary, the Bank's balance sheet already bloated by £375 billion of QE and liquidity being sparingly provided via the Funding for lending scheme, the only tool left for Mr Carney was verbal intervention (what central bankers now call "forward guidance"), or put another way, promise to keep rates at close to zero for as long as it takes.
Let's be honest here, compared to interest rates and money printing, forward guidance packs a very modest punch indeed. Perhaps the UK economy only needs a bit of cajoling to hit escape velocity; there has certainly been an improved tone to recent economic data. If this is the case, then as noted by many commentators this week, promising to keep rates low for an extended period may lead to too much borrowing (with attendant problems when interest rates finally rise) and possibly an inflation problem further out. Indeed, the Bank of England upgraded both their growth and their inflation forecasts this week and so perhaps the new forward guidance is simply not required.
Yet, despite the better tone to recent data and the up grade to forecasts, Mr Carney chose to strike a somewhat downbeat message during his press conference. Not only does the bank expect unemployment to fall from 7.8% to 7% in three years (seems like a long time to us), he spoke of continued headwinds. Perhaps he is hoping to under-promise and over-deliver. Perhaps he is being downbeat to justify his forward guidance when it may actually be unnecessary. Perhaps he just doesn't trust the recent data.
Whichever, he decided to press on with forward guidance, but with some caveats;
- So long as they do not expect inflation to be above 2.5% in the future.
- So long as their policies are not leading to financial bubble.
- So long as inflation expectations remain contained.
The cynics out there may say that he has given himself a lot of wiggle room to change the goalposts. Some will say that it is right and even prudent to give out the message that rates will remain low as long as necessary but only so long as inflation and financial excess do not get out of control .
What strikes us as odd about this forward guidance is that the Bank is tying itself to promise on future policy and is using lagging indicators (inflation and unemployment) to guide them. Each cycle has seen economic growth bottom well before inflation - in fact, inflation generally goes up in the early stages of economic deterioration. Also, the unemployment rate always peaks some way after the economic recovery begins.
The first chart below shows the relationship between UK GDP and the CPI inflation rate. We have lagged the inflation data to try and get abetter fit. Does this show inflation is a lagging indicator? We think so, and the economics text books tell us this is how it should be. It will be interesting to see whether the Bank of England's forward guidance policy actually generates sufficient growth in the economy to generate the jobs they are looking for and without creating inflation.
The next chart shows the relationship between GDP and the unemployment rate. We have advanced the GDP data by 20 months, and the unemployment data is inverted so as to show troughs in growth with peaks in unemployment. What is interesting is not just the correlation between the two (with unemployment being a lagging indicator!) but also the fact that unemployment held up so well during the last recession. This could be because there were a lot less corporate bankruptcies in this last cycle and perhaps the labour market is just that much more flexible. Whatever the cause, we have to wonder whether, having not collapsed as we would have suspected, the unemployment rate fails to recover as in previous cycles. If the unemployment rate remains sticky above 7%, will the bank be able to keep rates low even if inflation remains above 2.5%?
Clearly, the Bank is now following policies to promote growth and willing to be more "flexible" in targeting inflation at the same time. So does higher inflation lead to lower unemployment? Anyone who lived through the 1970s high inflation period will remember how high unemployment was at the time. The chart below shows the relationship between inflation and unemployment. What is clear is that low and stable inflation is desirable in terms of keeping unemployment low.
Our view is that Mr Carney has a very difficult balancing act. If the economic headwinds knock the UK economy off track, he really has very little left in the tank. Forward guidance will simply not be enough to support a struggling economy and QE is a great policy for inflating asset prices but seems to be less effective at generating real economic growth. On the other hand, if the economy is now improving, how can a central bank anchoring policy against lagging indicators hope to get ahead of the inflation curve? Our best guess is that in this scenario, the Bank will remain accommodative for far too long.
As we know, Mr Carney is not alone as all major central banks are struggling as they operate at the extremes of policy. Perhaps the UK will be better off than our competitors with Mr Carney in charge. It's not easy to know at this stage whether there are any obvious investment strategies that we should be implementing at this stage. Frankly, US policy, the Chinese slowdown, the Japanese reflation policies and lack of real progress in Europe are more powerful macro drivers at the moment.
Mr Carney certainly brings a different style to the Bank of England but for the moment we will reserve judgement as to how effective he will be.
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