In this week’s bulletin:
- New Bank of England governor Mark Carney’s plain-talking delivers his message loud and clear
- European Central Bank president Draghi also takes an unprecedented step of issuing forward guidance
- Tighter US monetary policy will signal economic recovery but poses challenges for emerging markets
Carney: a roar not a whimper
Words, as central bankers and markets know, can have a devastating effect. There was a cautionary example Down Under last week of the damage an ill-chosen phrase can inflict (which was unrelated to the drama surrounding Brian O’Driscoll and the Lions’ subsequent triumph in Sydney). The governor of the Reserve Bank of Australia made a joke about interest rates. The markets didn’t laugh. They dived.
Reserve Bank governor Glenn Stevens’ gag went something like this: he and his fellow Australian central bankers had spent a very long time deliberating about interest rates before deciding to do… nothing. J.P. Morgan, among others, issued a stern note puzzling over the substantial caveat suggested by the verb ‘deliberate’, gleaning an indication that rates could be cut in August. The Australian dollar plunged to a three-year low. The Reserve Bank was forced to confirm that the governor had meant to make a “light-hearted remark”.
Financial markets don’t do humour, or irony, or even Australian droll (although, curiously, the Reserve Bank has tried to talk down the dollar for months). And neither should central bankers, probably. Markets are to monetary policy statements as children are to parents’ instructions: they look for clear guidance (and central bankers, like parents, are at pains to keep them quiet).
It took a Canadian in London last week to show how plain-talking English can, in contrast, deliver a central bank message loud and clear. Markets expected a quiet announcement to follow the Bank of England’s new governor, Mark Carney’s, first Monetary Policy Committee (MPC) meeting on Thursday. Instead, the Bank’s new lion roared at those expecting an early rise in interest rates.
The European Central Bank (ECB) president Mario Draghi also broke with protocol last Thursday. At a conference in Frankfurt, Draghi said rates would remain at current or lower levels for an extended period of time. Previously the ECB had said it would not make commitments to rate strategy.
Draghi and Carney’s stance follows the US Federal Reserve’s unveiling of its strategy for a gradual tightening, or taper, of its quantitative easing (QE) programme. The Fed’s move last month brought an increase in bond prices and government borrowing costs. Both London and Frankfurt need to tame these to protect economic recovery.
Both interventions had an immediate impact on markets. The FTSE 100 Index hit a one-month high on Thursday, gaining 3.08%; while the FTSEurofirst 300 Index recorded a 2.44% rise, its biggest for 11 months. However, strong US payroll figures on Friday leant weight to expectations that the Fed will start to scale back its QE programme, pulling back the gain on the FTSE 100 for the week to 2.58% and the FTSEurofirst 300 to a 0.99% rise over the five-day period.
The arrival of Carney at Threadneedle Street has been accompanied by an almost messianic fanfare. There has been a steady reference to the new governor as a great communicator, while the world is hanging onto the words of the Albertan as good news gospel for the UK economy. Whether or not he can deliver economic miracles, his first utterances in the temple of the Bank have certainly made the markets listen.
The governor’s first distinctive move was to issue a statement alongside the MPC’s no-change stance on interest rates. Carney’s open-mouth policy made clear his thinking. It emphasised that markets are wrong to anticipate an exit soon from loose monetary policy and low interest rates.
Carney and the MPC are looking at using forward guidance measures to reassure about monetary policy. He is expected to use indicators known in Bank-speak as ‘intermediary thresholds’. Interest rates will be kept low if economic indicators – such as specified levels of unemployment or GDP – stay within set parameters.
As Bank of Canada governor in 2009, Carney used forward guidance measures to keep rates on hold. These guides are his preferred mechanism to control expectations of short-term interest rates. He also needs to encourage a more ambitious stance on the economy and more momentum – what he calls the ‘escape velocity’ – to lift the UK away from QE.
Carney last week acknowledged that the UK economy is still a long way from this level of growth. However, there is evidence of momentum gathering for the UK economy, with improved activity in the construction, manufacturing and services sectors in June. This week industrial production and trade figures for May will show if the turnaround is occurring.
Keeping interest rates low as the economy recovers offers monetary stimulus. The threat is too quick an uptake by the economy and rising inflation. The US Fed has shown that once guidance is in place, as it has been for almost a decade, a mere nudge of the brakes can jolt the markets hard.
Licence to sell?
The Bank’s new governor last week also criticised the recent sell-off in gilts. This was sparked by the US Fed’s announcement last month that it would gradually reduce its $85 billion-a-month bond purchases when its economic parameters are met. The run resulted in ten-year gilt yields surging from 1.6% in early May to 2.5% on 26 June. Investors were betting that interest rates would start to rise early next year.
Meanwhile, strong US employment figures issued on Friday sent bond yields climbing as markets reopened following the 4 July Independence Day holiday. The figures show some recovery in the US labour market, which is a criterion for the Fed to slow down its asset-purchase programme. The yield on ten-year US Treasuries rose by more than 20 basis points from 2.5% to 2.68%, which is the highest since July 2011.
The US economy added 195,000 new jobs in June, which was above expectations of 165,000, while revisions of figures for April and May added a further 70,000 jobs to previous estimates. However, the Bureau of Labor Statistics indicated that the jobless rate remains steady at 7.6% of the workforce, as jobs growth was offset by a rising number of people in the labour force. This is still shy of the 7% that would prompt the Fed to begin to end its third round of QE (QE3).
The rise in bond yields has also started to affect the US mortgage market. The average rate of a US house loan has risen above 4% for first time since last year, which means less affordable loans and potentially less money free for consumer spending. However, rising bond yields indicate that economic recovery is in the air.
‘Whatever it takes’
Within two hours of Carney’s statement last Thursday, ECB president Draghi had also taken the unprecedented step of offering forward guidance. Not only did Draghi pledge that rates would be kept low for an extended period, he also said there had been an extensive discussion among the central bankers about a possible cut. Another central bank meeting that was expected to be uneventful looked historic.
The ECB has had a longstanding policy of not pre-committing to future interest rate decisions. Draghi’s decision to issue forward guidance for the first time takes to a new level his earlier promise to do “whatever it takes” to safeguard the eurozone economy. One of the big questions for Draghi and Carney is the level of impact a gradual reduction of asset buying by the Fed will have on the eurozone and the UK.
The timing of the comments from Frankfurt, to coincide with Carney’s statement in London, for many looked like coordinated action to dampen market expectations of an early rise in short-term interest rates. However, Draghi insisted the timing was coincidental. He also insisted it was not a reaction to the Fed’s hints that it would ease its bond-buying programme.
Addressing the economic outlook for the eurozone, Draghi did allude to the implications of Fed policy. “The recent tightening of global money and financial market conditions and related uncertainties may have the potential to affect negatively economic conditions,” he stated. Eurozone industrial production figures for May are due out on Friday, with only a modest recovery expected.
Meanwhile, peripheral eurozone economies continue to teeter under the strain of austerity. Last week it was the turn of Portugal to undergo political and economic crisis; while Greece this week will look to eurozone finance ministers to free up its next €8.1 billion tranche of aid. However, as fears eased of a collapse of Lisbon’s coalition government and its €78 billion bailout programme agreed in 2011, Portugal’s ten-year sovereign yield continued to fall.
The US Fed’s indication of an impending gradual retreat from QE3 has also caused a stir in emerging markets. The Fed’s loose monetary policy has encouraged capital to look for alternative investments. Although capital coming into these markets has fallen in recent months, the retreat has not yet amounted to a mass exodus.
Some countries could benefit from stronger US growth that will be the trigger for the tapering of QE3. China’s economic slowdown is having an impact on commodity exporters, such as Brazil. Developing nations in recent years have enjoyed cheap money flowing into their economies, and a western recovery and demand for exports will be vital for many of these nations.
China’s move to rebalance its economy to a consumer-led model also means potential market volatility and social unrest. Mass protests and political unrest in Brazil and Egypt in recent weeks indicate the level of uncertainty that can engulf emerging nations.
The World Bank has also warned that debt-laden emerging markets are at risk if interest rates start to climb. The faltering momentum of China and the rest of Asia prompted the bank to cut its forecast for global economic growth to 2.2%. However, if growth in advanced economies can gather momentum then the resulting increased demand for emerging market services, goods and materials will be of benefit to the global economy.