Bank of England Monetary Policy Committee members were united in the belief that market pricing had been underestimating uncertainty, and they have certainly succeeded in shaking up rate expectations.
Governor Mark Carney’s remark, in his June 12 Mansion House speech, that the first hike could come earlier than markets had been expecting was a stark version of the committee’s views.
The MPC’s aim was not to get markets to shift to fully pricing in a 2014 hike, which is what happened straight after Carney spoke, but rather to get them to place greater weight on it.
Having long been pricing in spring 2015 as the most likely date for the first hike, money markets swung in the aftermath of Carney’s speech to fully pricing in a hike by November, but expectations have now drifted back to January.
In evidence to the Treasury Select Committee Tuesday Carney and colleagues were grilled about the Governor’s shock tactics in his speech and the Bank’s communications strategy. Deputy Governor, Monetary Policy Charles Bean summed up the MPC’s thinking, while declining to endorse Carney’s comments.
Asked if Carney’s remarks were advisable Bean said “I am not going to comment on whether they were advisable or not. The Governor is entitled to say whatever he likes in his speeches, as are all members of the committee.”
Bean stressed that the message from the MPC was a subtle one: not that it is now certain that the first hike will be in 2014 but rather that markets had been too complacent about policy risks.
In the discussions around the MPC June 4 and 5 policy meeting “We were all struck by the high degree of certainty that market participants seemed to have about the timing of the first increase in interest rates,” Bean said.
That was reflected in the minutes of that meeting, which stated that “the relatively low probability attached to a Bank Rate increase this year implied by some financial market prices was somewhat surprising.”
Controversially, the Bank’s analysis for the June MPC meeting said options prices suggested that market participants were putting only around a 15% chance on a rise in Bank Rate by the end of 2014.
That very low probability has been disputed by some analysts, sparking a debate over the technicalities of interpreting options pricing.
Irrespective of whether the BOE got its interpretation of options pricing right or not, Carney and his colleagues’ focus is on the bigger picture: that markets, in Bean’s words, have become eerily reminiscent of their pre-financial crisis days.
“It is a subtle point … that market participants underestimate the uncertainty of the environment that we, and they, are operating in,” Bean said.
“Implied volatilities on a range of assets appear to be unusually compressed, at below pre-crisis averages and that doesn’t reflect the degree of uncertainty. There are geo-political risks, economic risks, and so forth,” Bean noted.
The obvious criticism the MPC leaves itself open to is that it, and other central banks, have contributed to this excessive certainty through forward guidance.
Under Carney’s leadership, the MPC first adopted Guidance Mark 1, centred on the jobless rate and, Guidance Mark 2, which is centred on wider measures of labour market slack and offers reassurance that when rate hikes do come they will be gradual and limited.
MPC members’ defence is that their guidance has never been about the timing of the first hike – it has been state, not time, contingent in the jargon.
“What forward guidance has done is to allow the recovery to get underway, to build-up some head of steam, without that risk playing out of medium-term, 2, 3, 4, 5 year interest rates, moving up quite sharply … I think it has been quite successful,” independent MPC member David Miles told the committee.
“The noise around whether people think the first interest rate rise will come in December, or February, or March is, I think, largely noise,” Miles added.
Nevertheless, one lawmaker accused the MPC of acting like “an unreliable boyfriend” with its signals back in August interpreted as indicating there would be no rate hike until 2016, then bringing it forward to 2015 and then having Carney open the door to 2014 in his Mansion House speech.
“It strikes me that the Bank is behaving like an unreliable boyfriend. One day hot, one day cold, and the people left on the other side of the message are left not really knowing where they stand,” Treasury Select Committee Pat McFadden said.
Bean, however, took the view that the MPC was not unreliable at all – just much misunderstood.
“The big point of forward guidance was to be clear about the nature of the reaction function and we weren’t going to be raising interest rates simply because growth would come back and that that guidance was state contingent,” Bean said.
“People keep on saying we said that we wouldn’t think about raising interest rates until 2016. We never said that,” he added.
The MPC’s approach to highlighting the risks around policy is echoed by the US Federal Reserve, which faces a battle to avoid another “taper tantrum.”
Getting markets to move at least some way towards pricing in early tightening should help guard against excessive volatility as tightening comes ever closer to reality.
The time for a rate hike “may be sooner than people think,” Federal Reserve Chairman Charles Plosser said Tuesday, in a transatlantic echo of Carney’s remarks.