Great Expectations

26/02/2016 at 4:04 pm

A speech to the G20 summit in Shanghai from the Governor of the Bank of England has drawn some media interest today. Mark Carney’s words of caution to his fellow central bankers on the subject of negative interest rates centred on the “zero sum game” of seeking export-led recovery. He noted, quite rightly, that “beggar-thy-neighbour” policies at the country level would do nothing to address the sluggishness of global demand. And only on Tuesday he told the Treasury Select Committee that Britain’s policy rate would not go negative.

He did, however, say that it might be cut.

Sterling hit a new trade-weighted low on Wednesday and has now fallen by more than 10% from its August peak to a level last seen two years ago. Now the downward trend started back in November and has also received a helping hand from David Cameron’s successful reform of the European Union last Friday. But Governor Carney’s words, and those of his colleagues on the MPC this week, do undermine the credibility of his Chinese lecture at least a little.

This is especially the case since the pound’s impact on inflation has long been singled out in the Bank’s quarterly reports on the subject. A bout of moderate currency weakness could give a nice boost to CPI, if only on a forecast basis, bringing it closer to the target rate of 2% per annum without the MPC having to resort to any further loosening of policy over the coming months. And the side effect of a positive impact on British exports is just something the Bank would, regrettably of course, have to live with.

Look at the last Inflation Report and the underlying data, however, and even sterling is a side-show. As so often over the past 18 months the big news is oil.

This blog wrote about the impact of energy prices on the Bank’s assumptions for inflation back in November. Since then the effect has grown. Oil price assumptions for this year and next are down by 34% and 29% respectively; forecasts for gas prices down by 24% and 21%. On the MPC’s arithmetic this is in the process of translating into added deflationary pressure in 2016 of 0.4% p.a. by way of petrol prices and gas bills alone, with additional effects via the pass through of lower production costs (this being more difficult to time as well as to quantify).

It is, then, unsurprising that it has been oil, not sterling, which has exerted the more powerful pressure on interest rate expectations. These were already very benign, with UK rates only expected to rise late this year or some time into next. Look at futures markets today, however, and they are not pricing in any chance of policy tightening until the second half of 2018, with the base rate remaining under 1% until at least the end of the following year. As with the pound this change has been quite rapid. The 3-month LIBOR future for December 2019, which now prices at 1.02%, was priced at 2% on New Year’s Eve.

While the press looks to the pound, therefore, the rates market has been looking at the oil price.

And yet even the February Inflation Report is rightly cautious on this subject. It notes that the drag from lower energy prices will unwind over time, and that its CPI forecast on a three year view is broadly unchanged. Elsewhere it further notes that the labour market has strengthened more rapidly than expected back in the autumn: in fact it now forecasts UK unemployment of 4.8% both this year and next, revised down from 5.2% and 5.0% respectively. This is nothing less than a prediction of full employment, if the history of the last forty years is any guide. And at the same time the ratio of vacancies to the total labour force has risen again. This measure averaged 1.5x over the period 2010-12, when the UK labour market stagnated around an 8% level. Then it rose to 1.7x in 2013 and 2.0x in 2014, a time of rapid jobs growth which saw unemployment reduce to 5.7%. For 2015 the ratio hit 2.3x and unemployment already stood as low as 5.1% come December.

Under normal circumstances this would ignite at least an amber warning of cost pressures by way of wage increases. At present, however, this pressure is contained by the current low level of headline CPI, as the Bank also notes. (What the Bank doesn’t note but is nonetheless equally material is that low inflation has a direct impact on wage settlements in the public sector – about one in every six jobs in Britain – together with pensions and other welfare payments.)

The UK is close to full employment, the deflationary impact of a strong pound has fallen away in short order and price pressures are being contained only by the continued weakness of a commodity whose average annual price change in either direction over the last ten calendar years has been 30%. Interest rate markets are expecting this happy circumstance to persist for at least the next two to three years. From some perspectives – that of the property market, for instance – it would be lovely if they were right. But the more prudent thing to do, surely, is to think about what might happen if they are not.

Let us leave the last word to the Bank of England:

“At its meeting ending on 3 February, the MPC judged it appropriate to leave the stance of monetary policy unchanged . . . All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on the economic circumstances.

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