The belief that financial markets were underestimating the chances of a 2014 rate hike set the Bank of England’s policy communication machine whirring in June and early July, with Governor Mark Carney and colleagues shaking market complacency.
Market expectations had apparently set solid around the first hike coming in spring 2015 but the MPC’s interventions have jolted them back to life. The unchanged policy announcement on Thursday was inevitable, with analysts split, largely, between those forecasting a November 2014 and a spring 2015 hike.
Although some BOE watchers have argued the execution of the plan to shake market expectations was clumsy, it appears to have worked. Market expectations for the first hike have become de-anchored from spring next year – shifting around according to the data flow.
The likelihood now is the MPC will turn the volume down on its communications – having achieved the shock effect.
In his Mansion House speech on June 12 Carney said that the first hike in Bank Rate, taking it from its record low 0.5%, “could happen sooner than markets currently expect. But to be clear, the MPC has no pre-set course. The ultimate decision will be data-driven.”
The immediate market reaction to those remarks was to price in a November 2014 hike, since then expectations have drifted back and money markets are now pricing in the first hike in February.
MPC members, at the June 24 Treasury Committee hearing and in other remarks, have driven home their concern that markets were putting too low a probability on a rate hike this year and they wanted them to give greater weight to it. This, however, is not the same a signalling that a late 2014 hike is the most likely outcome.
Bank estimates, which some analysts disputed, showed that based on options pricing and sterling Overnight Index Swaps, before Carney gave his Mansion House speech markets were putting just a 15% chance on there being a rate hike this year.
The BOE is not publishing running estimates of what it estimates options pricing is showing. Nevertheless, as long as markets attach a substantial probability to a 2014 hike, it means the MPC can consider one without having to worry too much about an extreme market reaction.
Predicting when the MPC will actually hike is being rendered more complex by the changing personnel on the committee.
The MPC’s July 9 and 10 meeting was the first for Kristin Forbes, from the Massachusetts Institute of Technology.
Minouche Shafik, the new deputy governor responsible for markets and banking, will attend her first meeting in August.
It is hard to say with any confidence whether they will gravitate towards the more hawkish or dovish end of the MPC spectrum, with neither in their previous work having to express views on the UK economy and policy setting.
Through forward guidance, the MPC has put the spotlight on how much slack remains in the economy.
Shafik, a former senior IMF official, in her confirmation hearing on Wednesday, said the Bank was likely to reduce its estimate of how much slack remain – which was 1% to 1.5% of GDP in the May Quarterly Inflation Report.
“I think the next time those estimates are made they will probably be lower
because we have seen that output and employment have improved far better than we
had expected,” Shafik said.
“Spare capacity in firms seems to have closed. In the labour market there are two levels of spare capacity: unemployment, which has come down quite quickly and the other is the amount of people who are currently working part-time and who want to work more,” she added.
Even if the Bank does lower its central estimate of slack in the August QIR, it will not make the outlook much more certain.
Some MPC members, such as David Miles and possibly Carney himself, could still take the view there is more slack than in the central estimate.
There is also a debate over how soon the MPC should move. Theory says as policy acts with a lag policymakers should tighten before the output gap closes altogether, but no committee members have put figures on how close to zero they should go.
“A prudent policy maker, in my view, would want to start to remove some of the current extraordinary level of monetary stimulus a little before the output gap is fully closed,” MPC member Ian McCafferty said on June 19.
The current data show the economy is still growing above trend, but forward looking business surveys, notably the British Chambers of Commerce survey out this week, leave it open to debate whether the pace of growth will be maintained or ease a touch in the third quarter.
The near term inflation outlook seems benign, with a surprisingly low CPI outturn in May of 1.5%, comfortably below the 2% target, and the British Retail Consortium Shop Price Index showing record high street deflation in June.
While this could eases the pressure on the MPC for early action, further rapid falls in the jobless rate will point in the opposite direction.
As a result markets and analysts’ expectations are likely to keep moving around, particularly if the first dissenting votes in favour of a hike emerge next month.
The BOE is likely to be pretty relaxed about the volatility.
“The noise around whether people think the first interest rate rise will come in December, or February, or March is, I think, largely noise,” MPC member David Miles told the Treasury Committee.