Bank of England Governor Mark Carney and his colleagues have aimed to increase market volatility and shake participants out of their settled view that the first rate hike would come around spring 2015, and they are now leaving analysts guessing when the first move will come.
The financial stability and monetary policy wings of the Bank, both presided over by Carney, have been driving home the same message: that markets should attach a higher probability to risks, whether geo-political or of an earlier rate hike.
In evidence to the Treasury committee Tuesday Carney said the MPC is not offering guidance on when the first rate hike will come, just that it will be data driven.
The committee instead is only providing guidance on the medium term rate outlook, with increases expected to be limited and gradual.
“We don’t know exactly when the rate cycle is going to start. It will be driven by the data. We do expect markets to react to that data and the guidance we give is a likelihood over the medium term,” Carney told the Treasury Committee.
Carney delivered a shock in his June 12 Mansion House speech when he said that the first hike could, depending on data flow, come earlier than markets were expecting.
The knee jerk reaction in money markets was to bring forward the most likely date for the first hike from spring 2015 to November this year. What Carney was aiming to do, however, was simply to get markets to place a higher probability on an earlier hike – not to get them to shift to assuming a 2014 hike was a done deal.
Carney drew comfort from the fact his remarks only dislodged short term rate expectations, leaving medium term ones steady. At present, money markets are pricing in Bank Rate rising to 1.25% in around a year’s time, 2.0% in two years and 2.5% in three.
“When I made my comments at Mansion House what one saw was an adjustment to those comments, a bit of a pick-up in volatility relative to data, reaction to short-term data, but the medium term outlook for interest rates has not changed,” Carney said Tuesday.
One grumble from some market participants is that the BOE, by adopting forward guidance alongside other central banks, has been responsible for the over confidence in the timing of future rate hikes and increased risk taking.
Carney and his colleagues who were also in front of the Treasury Committee, Don Kohn, the Federal Reserve veteran who now sits on the BOE’s Financial Policy Committee and Deputy Governor Andrew Bailey accepted there was something in this, but that it was only true up to a point.
Asked if the low volatility and low risk premia that are concerning policymakers were a result of forward guidance, Kohn said “I think they are partly a result of forward guidance.”
While central bank assurances on policy setting do, and are designed, to get people to act on them, lowering volatility, “I think there are other things at play here too,” Kohn said.
The gradual recovery from the recession and the growing belief that neither the US nor the UK will sink back into one has also prompted the sense of complacency in the markets, Kohn believes.
Bailey noted that market pricing gives no indication of the rising concern, evident in surveys of market participants, over geo-political risk, in Iraq, the Ukraine and so forth.
The increased political risk “doesn’t seem to be moving anything in terms of implied volatilities of markets,” Bailey said.
Market’s failure to price in risk in broad swathes of assets goes well beyond assumptions about central bank policy setting.
Carney himself acknowledges that central bank reassurances that there will be no sharp rise in interest rates has added to risk taking and the search for yield.
“It doesn’t take a genius to figure that the relative predictability of interest rates in a low interest rate environment encourages risk taking, and we fully understand that,” the BOE Governor said.
However, other factors at play in reducing volatility were: the proximity of Bank Rate to the zero lower bound, distorting the balance of risks as it is highly unlikely to go lower; the further easing from the European Central Bank and the Bank of Japan and structural change in the financial system.
On the financial system side, Carney cited the spread of mark to market and the rise of indexed funds, which fuel “trend following”.
While the financial stability arm of the Bank can try and shore the system up against the threats posed from low liquidity and low volatility, the MPC has moved to tackle the problem of over-certainty on rate setting.
“The only guidance that the MPC is now giving is around the medium term perspective, the medium term path, of interest rates – not the timing of the first move,” he said.
In reality, the MPC will end up giving markets a decent steer beyond asking people to follow the data.
Past practice shows that, absent shocks, the MPC is far more likely to shift policy in Quarterly Inflation Report months, and the hot debate at present is whether the first hike will come in November or February, QIR months.
Secondly, policy changes tend to be trailed by dissenting votes at the monthly MPC meetings, and again the first dissents are more likely in a QIR month.
The August 13 QIR and the minutes of the MPC August meeting, out on August 20, will be key pointers to whether a November hike is plausible.
If no MPC members break ranks in August in favour of a hike, the likelihood attached to a November move is going to diminish, probably markedly.
Any speeches and interviews in coming months which reveal how much weight members attach to arguments that are not data dependent – such as the case for moving earlier to ensure the path of increases is gentle – could also shift expectations.
The data themselves continue to throw up puzzles – with Wednesday’s labour market data providing ammunition for both hawks and doves.
The jobless rate fell to 6.5%, the upper limit of the Bank’s estimate of the equilibrium rate while earnings growth hit an all time low at just 0.3% on the year.
Small wonder some analysts are putting 60/40 or 40/60 chances on a November or February hike.
MPC members, meanwhile, give the impression of being quite content with that level of uncertainty.