In this week’s bulletin:
- The Bank of England unveils “forward guidance” to steer the UK economic recovery.
- Signs of Britain’s economic turnaround are looking more robust each week.
- Interest rates will be kept at 0.5% until unemployment falls below 7%.
- Three more years of ultra-low interest rates will benefit borrowers but hit savers.
Timing is all
Good timing counts a lot in central banking, and the Bank of England’s new governor has displayed a deft grasp of this since his arrival last month on Threadneedle Street. Governor Mark Carney started his new role as the strongest stirrings yet of an economic recovery appeared at the height of Britain’s summer. And last week the former head of the Bank of Canada unveiled his new monetary policy approach of “forward guidance” to steer Britain clear of its recent downturn amid further signs of economic confidence in the UK.
After two decades of setting interest rates to target inflation, the Bank has added a further target – unemployment. Carney’s forward guidance is a commitment to keep the interest rate at a historic 0.5% low until unemployment levels fall below 7%. And the policy comes with a number of escape clauses, or what the Canadian governor calls “knockouts”, to demonstrate the Bank will not tolerate risks to price or financial stability.
Carney’s forward guidance is an attempt to offer greater clarity for markets, business and households while pursuing a policy to keep interest rates low until prescribed economic conditions are met. Carney says this reduces uncertainty about the future path of monetary policy as the economy recovers and helps financial decision-making. The Bank’s forecasts indicate that this unemployment rate will not be met until mid-2016, which, if correct, will keep interest rates at ultra-low levels for another three years.
The reaction of UK financial markets was muted to both Carney’s new tack and further news of the UK’s economic recovery. The markets have taken the Bank’s new approach as an indication that policy remains in the balance, despite Carney’s efforts to present his forward guidance as its name suggests. Gilt yields and sterling rose last Wednesday. The FTSE 100 index fell 1.4% to 6,511 on the announcement of the new policy direction, and closed the week down 0.97% at 6,583 after a 0.83% rally on Friday.
The attention of global markets was more attuned to central bank policy and economic data from China and the US. Chinese official data for July showed increased factory production of 9.7% beating 9% forecasts, suggesting efforts to counter the nation’s slowdown in growth are having some effect. Meanwhile, the US trade deficit in June was at its narrowest for almost four years, while service industries in July expanded at the fastest pace in five months. However, US markets continue to twitch over when the Federal Reserve will start to taper its $85 billion-a-month asset-purchase programme, triggered by this recent raft of good economic news.
Global market indices remain close to their recent record levels in the holiday month in which trade volumes traditionally slacken. In the US, the S&P 500 slipped 1.1% over the week to settle at 1,691, although it is up 20% since the beginning of the year. Meanwhile, the FTSEurofirst 300 gained 0.4% for the week amid a spate of good corporate earnings statements. The Nikkei 225 ended the day on Friday slightly higher, but over the week fell 5.88% on disappointing quarterly corporate earnings.
Back to work
Carney’s new approach is in line with the US Fed’s “state-contingent” guidance on economic conditions that might lead to a rise in interest rates. The new tactic makes unemployment levels an explicit tool and target of the Bank’s monetary policy. Consequently, investors can expect monthly employment data to figure prominently for markets.
The Bank believes that unemployment figures as a threshold for interest rate changes are the most effective indicator available to monitor the recovery and wellbeing of the UK economy. Uncertainty about why productivity has been weak since the UK’s 2008/2009 financial crisis also prompted the Bank to turn to jobless data for indications of spare capacity for economic growth. UK unemployment levels currently at 2.5 million, or 7.8% of the population, are a readily observable measure for the wider public too.
Carney, however, does not think that the present unemployment rate, which was down 0.2% in the three months to May, will fall below 7% until mid-2016. But he does estimate that arriving at that 7% level over the three-year period will amount to around 750,000 jobs. The Bank believes that a lower unemployment rate of 6.5% is more consistent with a healthy economy. Its Albertan governor stressed that the 7% level is not a trigger but a threshold, or what he calls a “way station”, for the Monetary Policy Committee (MPC) to reassess the state of the economy.
If the Bank’s forecasts are correct about unemployment levels, its new governor will oversee three more years of cheap borrowing to help lift the economy. However, if the 18–24 month forecast for inflation rises above 2.5%, or medium-term inflation prospects worsen, or low interest rates start to threaten financial instability, the Bank will review its policy. Markets reacted unfavourably to these three caveats as offering too much room for a change in policy and creating too much uncertainty around the guidance.
However, Carney last week appeared more concerned about wooing business and households than financial markets. Following his rebuke in July of markets for jumping the gun on interest rates, he reiterated that gilt yields had risen too high in the past few months. He saved his charm offensive to reassure borrowers that there will not be a rapid exit from recent interest rate conditions, which was bad news for savers already four years into record-low deposit rates.
Britain in bloom?
The good news for Britain is that signs of economic recovery this summer are becoming clearer and more frequent. Last week brought more solid data for trade, construction, manufacturing and services. The green shoots of Britain’s economic recovery are looking more robust as 2013 progresses.
Office for National Statistics data indicates that the economy grew by 0.6% in the second quarter and 0.3% the previous quarter. Meanwhile, the Chartered Institute of Purchasing & Supply and Markit’s purchasing managers’ index for July indicate that the UK’s service sector experienced its strongest monthly growth rate since late 2006. UK factories’ June output rose faster than expected by 1.9%. The construction sector grew month-on-month by 1.4%. And the June trade deficit narrowed to its lowest level since the start of the year.
The economy is moving from “rescue to recovery” as Britain’s chancellor George Osborne has reprised since June. However, Carney is still cautious about the extent of Britain’s economic revitalisation. “This remains the slowest recovery in output on record,” Carney said last Wednesday. “We’re not at escape velocity right now.”
Carney’s term ‘escape velocity’ denotes the point at which a recovery breaks free of the constraints that were holding the economy back and becomes self-sustaining. The MPC’s guidance on interest rates is an attempt to encourage that take-off. With real growth typically expected to be about 2% a year before it generates profits for firms and more jobs, Carney’s caution last week may already be a touch of Canadian understatement.
Three more years of low interest rates will be a fillip for homeowners and landlords. But the prolonged low-interest environment is by no stretch of the imagination welcome for savers and pensioners. Growth-hungry investors, however, could see recovery and ultra-low rates fan further momentum in assets such as equities.
Mortgage brokers say the Bank’s forward guidance will help keep mortgage rates low and bring a possible further fall in borrowing costs. The government’s Funding for Lending Scheme (FLS) has already brought fixed rates to historic lows. The FLS has meant that banks have not needed to attract money from savers to lend out as mortgages. The potential end of FLS in 2014, however, could bring an improvement for saving rates.
Savers will have to accept that low returns on cash in recent years are likely to continue into 2016, if the Bank’s forecasts are correct. Four years of record-low interest rates have eroded UK savings and reduced disposable income. Pre-retirement investors looking at purchasing an annuity also face low gilt yields.
A mix of low interest rates and inflation is a bitter pill for savers. However, with economic revival still only in its early stage and incomes under pressure from price rises and inflation, the interests of Britain’s savers have been relegated for a greater good. Carney holds the view that an economy back on its feet and creating wealth has to be the ultimate goal for all, whether lender, saver or borrower, business, households or markets.
Many investors faced with low interest rates have looked to alternatives to boost their investment income and returns. We remain of the view that a balance of assets in a well-diversified portfolio, which is targeted to meet long-term objectives, is the only way to deliver good long-term returns. Equity markets look well supported by improving global trade and low interest rates, but remain subject to sudden shocks. Other asset classes, such as property and bonds, bring stability, if without the prospect of significant returns in the coming months.
Economic recovery, forward guidance on low interest rates and unemployment levels will define the discussion of the UK economy up to and beyond the 2015 election. Political debate will be fuelled by the Bank’s UK growth forecast upgrade to 1.4% this year, 2.5% in 2014 and 2.3% in 2015. It will also focus on the CPI inflation rate, which was 2.9% in June and will remain this year close to 3%, and above the 2% target.
The Bank last week said little about the other pillar of UK monetary policy – the £375 million quantitative easing (QE) programme. Many took this to indicate that it has drawn a line under its bond-purchase scheme, although it looks like it will stay in place until the unemployment target is reached. While QE has helped equity markets over the last four years, it continues to suppress gilts. Developments on the other side of the Atlantic in coming months, however, will exert influence on UK markets. Global investors are still bracing themselves for Fed chairman Ben Bernanke to wind down his QE programme, as the US economy recovers.
Carney last week reiterated that the Bank would not call a premature halt to its stimulus package. The governor recounted the cautionary tale of Japan’s economy and its too-rapid withdrawal of central bank support in the 1980s, and the ensuing decades of low interest rates and stagnation. The Bank didn’t want to make the same mistake, Carney assured the BBC. He went on to state that the Bank had “tremendous sympathy for savers but the best way to get interest rates back to a normal level is a strong economy”. Carney wants to give the nation’s economic recovery time to mature. Britain’s most high-profile Canadian views this objective as a common pursuit.