Markets yet to be convinced

The release of the Bank of England’s Inflation Report last week provided the usual comprehensive overview of UK economic issues. Although it makes a nice change to be looking at economics rather than politics, it did raise a number of important questions. One of the more interesting issues was the interest rate assumptions upon which the forecast was conditioned. The BoE has always made it clear that it uses current market expectations, which is perfectly acceptable, but it does raise a chicken-and-egg issue.

The problem is this: Markets currently expect only one interest rate hike of 25 bps during the BoE’s three year forecast horizon (chart). Based on this assumption, the economy grows more rapidly than the estimated rate of potential growth with the result that by 2022 the UK is projected to show a demand gap of 1% (i.e. a level of measured GDP which exceeds the economy’s potential GDP by 1%). Governor Carney made it clear that if the economy does run in line with this forecast, interest rate rises would be “more frequent than financial markets currently expect.” Naturally the headlines screamed that “UK interest rates are set to rise” but this is to ignore the fact that the market has reduced its expectations by about 50bps in the last six months. Taking Bank Rate from its current level of 0.75% to 1.5% by mid-2022, as the market was expecting in November, implies 25 bps of monetary tightening per year which is hardly going to derail the economy.

We should thus interpret Carney’s warning as an indication that he believes the markets have become too complacent – a view which is hard to disagree with – and the Bank was very clear in telling us that it is sending a message. The implication was that if the forecast is conditioned on higher interest rates, the positive demand gap would also be lower thus reducing potential inflationary pressure. However, this raises the question of whether the forecast is the BoE’s best guess of where it believes the economy is heading or whether it is merely a device to signal where interest rates are heading. If it is the former, there is an argument suggesting that the BoE should use its own interest rate assumptions in calibrating the forecast. And if the latter, why bother producing a forecast at all?

As it happens, I do not set much store by the latter possibility so I will ignore it. But the idea that central banks should communicate their future policy responses to a given set of outcomes is an attractive one. After all, the Swedish Riksbank sets out an indicative path for interest rates conditional on its economic projections. One advantage of this approach is that it does make the central bank reaction function totally explicit, and at a time when forward guidance is an important tool in the policy armoury, such transparency is helpful. But the difficulty is that the press and the markets will require a lot of education in order not to treat this as an unconditional forecast and in the case of the BoE, this might introduce more noise into the system than is warranted. Accordingly, the strategy of taking current market pricing and using this as a forecast conditioning assumption is, in my view, an acceptable compromise.

One other aspect of the BoE’s forecasts worth noting was that, despite the presence of a positive output gap and the forecast of an unemployment rate falling to 3.5% by 2022, the projected inflation pickup was minimal. Wage growth is expected at only 3¾% on a three-year horizon whilst CPI inflation is only slightly above target at 2.2%, and whilst the BoE argues that higher inflation will only show through with a lag, this nonetheless assumes a much changed relationship between unemployment and wages compared to the recent past. On my estimates, an unemployment rate of 3.5% would result in wage growth of 6% based on a Phillips curve estimated over the period 1998 to 2012. The fact that such a tight labour market results in sub-4% wage inflation is a good outcome for the BoE and implies labour will remain fairly cheap.

At the same time, the forecast also assumes that business investment growth will recover to a rate of 5.5% by 2022 – double the rate recorded between 1998 and 2007. To the extent that cheap labour and Brexit uncertainty has prompted firms to increase their labour hiring over the past couple of years at the expense of capital investment, this raises a question of whether firms will indeed simultaneously raise investment in future whilst continuing with this rapid pace of hiring. In other words, will firms cut back on labour input in order to expand output now that they are once again relying on capital investment? And if they don’t, might the unemployment rate not fall as far as the BoE expects? Moreover, if investment is picking up, surely this will raise the potential growth rate and reduce the likelihood that the demand gap will hit 1% of GDP which in turn will reduce the inflationary threat?

Obviously, there are lot of unanswered questions here and we will only know the answers ex post. But the point I am trying to get at is that there are some nagging issues about the nature of the forecast that don’t quite stack up. And it is for this reason that markets remain unconvinced of the BoE’s efforts to talk up the prospect of interest rate hikes. Forward guidance may be one of the new policy tools but it has to be used wisely. Markets will stop listening if central banks tell them they will raise interest rates but don’t follow through. Sometimes the best form of communication is direct action and if markets are taken by surprise, so be it!