Will they, won't they?

The BoE’s Monetary Policy Committee meets next week to decide whether to cut interest rates. It is likely to be a close call. The markets currently assign a 50% probability to such an outcome (chart). Never before have we been so close to an MPC meeting with the markets so undecided, which would appear to put some questions against the policy of forward guidance by which outgoing Governor Mark Carney set so much store.

Turning first to the rate decision, I am, like the markets, unsure how the MPC will vote next Thursday. There are equally good arguments in favour of a rate cut and for rates on hold. The case for a cut is derived from dovish comments from MPC members in recent weeks and a raft of data showing that activity slowed sharply towards the end of last year. GDP in November contracted by 0.3% versus October, suggesting that Q4 GDP will struggle to register positive growth, whilst CPI inflation remains well below the 2% target with the 1.3% rate in November representing the slowest pace in three years. On the basis that if a rate cut is likely to happen at some point, now is as good a time as any.

Against that, survey data has shown a significant rebound in recent weeks with the CBI balance of industrial optimism rising from a recession-indicating -44 in October to a much more comfortable +23 in January. In addition, the flash PMI estimates on Friday showed a sharp rebound, particularly for services, with the index rising to 52.9, the highest since August. The calculation that the MPC must now make is whether this rebound is likely to translate into the hard data, or whether it represents a false dawn, in much the same way as the post EU-referendum weakness in the summer of 2016 did not herald an economic collapse. There is also a question of whether the MPC wants to bind the hands of incoming Governor Andrew Bailey who will take up the reins in March.

Whether the BoE should be cutting rates at all is another issue entirely. I have long argued that the era of low interest rates is having adverse effects on the economy, with my particular concern being the impact on savers, particularly those saving for pensions. But in his most recent speech, Carney argued “the vast majority of savers who might lose some interest income stand to gain from rising asset prices that result from monetary policy stimulus.” That does not wash I’m afraid. Most households’ wealth is held in the form of housing, and unless you can somehow realise the wealth, whilst still maintaining a roof over your head it is not going to compensate for the income foregone in our pension pots. But it does illustrate the relaxed view of many central bankers, particularly in the Anglo Saxon world, towards low interest rates. It is not necessarily a good indicator of where Carney’s sympathies will lie next week but it is evident that he is not averse to taking rates lower if necessary.

I will provide a more comprehensive retrospective of Carney’s tenure another time but whilst he has generally done a good job as Governor there are some areas where his policy prescriptions have proved more controversial than anticipated. Recall that seven years ago, when Carney was about to be installed as BoE Governor, he extolled the virtues of forward guidance as a way of reducing the kind of uncertainty that markets are experiencing today. It is designed to supplement policy options when interest rates are at the lower bound and I discussed some of the pros and cons in this post. But it is ironic that ahead of Carney’s final MPC meeting the BoE’s communications remain as opaque as ever. In my view, this raises the question as to whether the policy itself is flawed or whether it is the BoE’s execution which is the problem.

In a paper published by the BoE in 2017 the authors noted that there are two sources of uncertainty associated with forward guidance. “First, uncertainty stemming from the fact that forward guidance announcements are incomplete descriptions of state-contingent policy behavior”. Secondly, “forward guidance promises may be imperfectly credible ... There is a well-known time-inconsistency problem associated with such promises. Namely, that the central bank has an incentive, once the recovery has taken hold, to renege and tighten policy earlier than originally promised.” This in turn leads “to uncertainty about future policy and an associated reduction in the effect of the forward-guidance announcement on interest-rate expectations.”

Clearly there is no question of the BoE raising rates earlier than anticipated. Quite the opposite in fact. But arguably, the forward guidance policy is an “incomplete description of state-contingent policy behaviour.” Part of the problem stems from the fact that there are nine MPC members, each of whom may have a different view of the current state of the economy, with the result that the state-contingent policy response is likely to differ in each case. We have heard from a number of MPC members since the turn of the year. Carney suggested that “much hinges on the speed with which domestic confidence returns.” On the basis of recent evidence that is an argument to maintain policy on hold. But his colleague Gertjan Vlieghe noted that he would need to see “an imminent and significant improvement in the UK data to justify waiting a little bit longer” – a view shared by another MPC member Silvana Tenreyro. But the big question is whether the recent set of data constitutes such an improvement?

The problem markets have is that they understand the publicly communicated positions of MPC members but they have been left in the dark regarding their reaction to the most recent data. This is a result of the BoE policy which imposes a communication blackout in the 8-9 days leading up to the interest rate announcement. Whilst this policy has been imposed with the best of intentions, it does highlight one of the unsatisfactory elements of forward guidance by preventing communication when it is most needed.

As former Fed Chairman Alan Greenspan said before a Senate committee in 1987, “If I seem unduly clear to you, you must have misunderstood what I said.” More than 30 years later, and after all the efforts by central bankers to improve the way they communicate with markets, it appears that some things never change.