Sterling bulls will be cheering Mark Carney and David Miles this week, as their TSC comments and speeches have propelled GBP sharply higher, with EURGBP falling through the important 0.70 level. And this again looks to have been driven by diverging monetary policy expectations, as proxied by swap rate differentials, as expectations of the first MPC rate hike have been brough forward to around February.
The EUR was also hurt by the improvement in risk appetite following positive news on the Greek crisis (even if Greece’s long-term debt sustainability remains contentious), rebound in Chinese equities (helped by official support and better Chinese data) and Yellen’s positive comments. As I anticipated in my posts of 22 June and 6 & 10 July, this higher risk appatite caused the EUR’s post-QE funding currency characteristic to again kick in.
Sterling’s renewed strengthening is not completely unexpected: my 2 July blog discussed the likely upward pressure generated by the UK’s tightening labour market/strong growth momentum combined with MPC’s likely pragmatism about moderate, fundamentals-driven sterling strength. But the impetus certainly came sooner than expected – the August Inflation Report seemed like a more obvious trigger – and from the unexpected source of two previous doves (although David Miles questions such labels).
Carney’s signal about likely rate hike votes around end-year – “the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year” – grabbed the headlines. But there are some other important details which have received less attention. In particular, the main points I take from this week’s developments are:
Risk management arguments for delaying rate rises face an uphill battle gaining traction in the UK
• Carney argued that “the healing of the financial sector and the lessening of some of the headwinds facing the economy, that concern [the constraint imposed by the effective lower bound on policy rates] has become less pressing with the passage of time” and “In the current circumstances there is no need to wait to raise rates because of a risk management approach and run the risk of inflation overshooting target” and . • Miles weighed in with “waiting too long to start on a path back to a more sustainable rate is a bad mistake. What you really need to avoid is sharp rises in interest rates.” And “I do not attach great weight to the idea that starting this process will create great risks of dropping back into very weak growth, falling into negative inflation and engendering a splurge in risk avoiding behaviour.”
• BoE Chief Economist Andy Haldane has been trying to promote a risk management approach. His 30 June speech argued that the after-effects of the financial crisis mean, intermediated via “dread risk” and “recession risk”, means that households and firms will adopt a “glass half full” approach. But, at a simplistic level, that argument is hard to square with elevated consumer confidence, with especially high readings on “good time to make a major purchase” balances.
MPC are evolving how they to try and differentiate themselves from the FOMC, focussing on the path’s slope not the liftoff date, which could have risks
• Among the most surprising elements was David Miles’ argument that “it is a daft idea that we cannot raise rates in the UK before the US”.
• That contrasts with the generally dovish interpretation of the June MPC minutes statement that “the path for UK monetary policy…would not be determined by the actions of other central banks” i.e. that a FOMC rate hike would not pressurise MPC into raising rates (and would therefore help hold GBP down).
• So the strategy of differeniating MPC from FOMC it is now very much about the path of UK rate hikes being shallower than US rate increases. Of course, MPC have been arguing tha UK rate rises will be slow for a number of months. But Carney’s calibration that rates would “rise to a level in the medium term that is perhaps about half as high as historical averages” of around 4.5% is the most explicit yet. The back-up observation that the maximum post BOE independence rate hiking cycle has been around half the size of the average US rate hiking cycle is also new. And reinforcing the well-known fact about the greater preponderance of floating rate debt in the UK, on the UK’s higher debt burden, was notable.
• That said, David Miles’ back of the envelope calculations suggest that a neutral Bank Rate (r*) of 2.5-3% at the start of 2018, substantially higher than implied by the yield curve at the time of the May IR. So there is obviously room for disagreement amongst MPC members about just how much lower r*, potentially reducing the credibility of the “sooner not higher” argument.
• Plus, of course, the after-effects of the financial crisis will likely have also reduced r* in other countries. And it is extremely difficult to calibrate cross-country variations.
• So there is a risk that MPC accepting that the UK could be the first to raise could cause the market to start pricing even sharper UK rate rises, even in advance of that debate being settled, pushing GBP to levels where MPC does start getting concerned. The rationale could be “MPC got it wrong on the fall in unemployment during the initial forward guidance period and this is another difficult call” and so question the analysis.
• That said, the market may well treat Miles’ remark as an academic debate or a personal view. The US recovery is more mature (they sorted out their banking system earlier and have a lower exposure to the euro area) and following Yellen’s recent comments the debate continues to be whether liftoff happens in September (advocated by 70% of economists) or December (more support from market pricing) rather than what Carney’s “come into sharper relief around turn of the year” means in practice. And of course we do not know whether other MPC members share Miles’ view, although he has previously been at the dovish end of the spectrum.
MPC seem, for now, relatively pragmatic about GBP strength.
• Carney mentioned the persistent impact of GBP movements on core inflation, but relegated the detail of the argument to a footnote in his speech and stressed at TSC that the prospective rise in domestic costs dominate it.
• He also stressed that the MPC does not have a target for sterling (unlike other Central Banks like the RBA) and the benefits of a freely-floating exchange rate (UK open for business etc). This foregoing of the opportunity to point out how close the REER is to its pre-crisis level, as discussed my 2 July blog, is consistent with pragmatism about not second-guessing the market.
• And Carney’s TSC comments were about exchange rates being generally linked to economic fundamentals, albeit with temporary deviations. MPC seem less likely to oppose fundamentals-driven GBP strength e.g. one driven by continued ECB QE which helps support EA demand and hence UK export prospects.
• Carney and Miles must also have realised that their comments would boost GBP. So, by revealed preference, they cannot be that worried that GBP strength will undermine the recovery (considering GBP in the round).
• The lack of comment on manufacturing’s underperformance – manufacturing output is flat on a 3m/3m basis and the gap between the manufacturing and services PMI is the largest for a number of month – was also notable.
• Another footnote to Carney’s speech reveals, however, that MPC expects to refine its estimates of the effects of GBP movements on inflation in the future – potentially meaning that they place more weight on the detail relegated to a previous footnote (see above) and hence become more resistant to further GBP strength. Watch this space.
MPC also don’t seem that concerned about the UK’s large current account deficit
• The TSC comments outlined a number of reasons for downplaying the current account deficit, although it is the largest in the advanced economies: it had been caused by lower income of foreign (EA) investments which seemed likely to reverse as the EA recovered; the net international investment position (i.e. net assets) had actually improved thanks to valuation effects; its counterpart was not an unsustainable consumption boom but the well-known large fiscal deficit (so the common approach of equating them to additive risks seems flawed); it was being financed by stable long-term flows rather than short-term speculative flows which were sterling-denominated (no FX mismatch).
• As such, the FSR identifying it as a key risk was downplayed and the reference to it being a bank stress test scenario made it sound like a bit of an academic exercise.
• I would add that, as detailed in my 2 July blog foreign investors have been making substantial gilt purchases in recent months and indeed UK assets have been regarded as a safe haven during the Greek crisis.
The risk of MPC wanting to see more evidence before buying into the wage uptick story has not materialised.
• Andy Haldane argued that “one swallow does not make a summer…wage growth is causing some fluttering, but not in this dovecote…Wages are not about to embark on a rocket-propelled ascent”.
• So, as I discussed in my 2 July blog, it was possible that other doves would also need to see a relatively long string of upside wage surprises before thinking about rate rises – the market risked getting ahead of the MPC by extrapolating from a couple of good AWE numbers.
• But Carney argued that rapid falls in unemployment and the vacancy/unemployment ratio rising back to pre-crisis levels were optimistic signs and that “recent data give welcome reassurance that the risks associated with a deflationary mindset in the labour market have likely fallen significantly” i.e. low inflation has not fed into low wage demands/settlements.
• It is also possible that non-linearities/threshold effects could start kicking in with wages only really start rising when the pool of unemployed workers is close to being exhausted and firms have to entice already-employed workers to switch jobs, requiring higher pay. Carney referenced such job-to-job flows being around pre-crisis highs.
• But the MPC still need to see earnings growth rise to 4% to be consistent with the 2% inflation target.
MPC appear cautiously optimistic on the long-standing low-productivity puzzle disappearing
• They seem willing to believe that the small increase in productivity apparent in Q1 data, which have been revised up as more data have accrued, marks the start of an uptick
• They see the healing of the banking sector as important in facilitating better productivity – banks are now better able to absorb the losses from letting “zombie” firms go to the wall, allowing for better allocation of resources (creative destruction).
• They also continue to expect a strong investment profile to support productivity, and do not see any evidence of BREXIT risks undermining investment plans.
• But they also acknowledged that rates will have to rise more quickly if productivity doesn’t pick up. So FX traders may now start being avid viewers of UK productivity data.
Those points hold even though David Miles’ last MPC vote is in August. The Chancellor may well struggle to find anyone more dovish (while also possessing Miles’ credibility). And the fact that a previous dove has flown is consistent with a more general shift in focus occurring within the MPC. There seems to have been a change of mindset, reflecting the accumulated evidence on the economy growing above trend and wages picking up and the desire to avoid later sharper rate rises. So they seem to have shifted quite a long way from the May Inflation Report’s focus on the headwinds associated with the aftereffects of the financial crisis.
So while the odds are good that both Weale and McCafferty vote for a rate hike in August, other MPC members could join them fairly promptly. Here previous comments suggest that Forbes, Shafik and Cunliffe could be the most likely to switch to rate rises, although obviously inference is imprecise given the judgements implied and the quickly-changing environment. But given the above, I would expect that the negative skew on the inflation forecast to be substantially cut or dropped in the August Inflation Report, as a first step for preparing for a November or February rate hike.
Deciding on whether November or February is more likely (presuming that such a significant rate move will take place in an Inflation Report month) is a tough call which requires further analysis. My gut feeling is that it could well take until February to get a (slim) majority, given that some MPC members could yet maintain that risk management has benefits. But Carney has made clear that the decision will be very data dependent, rather like the FOMC, and that the MPC will “have to feel its way as it goes”. He also seems to have borrowed from the FOMC s lexicon in arguing that he needs to have a “reasonable expectation” of inflation returning to 2% within 2 years (i.e. echoing the FOMC’s “reasonable confidence”).
The bottom line is that GBP is likely to be sensitive to MPC utterances over the coming months. The August IR will, of course, be the first time that the MPC minutes are released at the same time. So we could well, hopefully, have a more open and fruitful discussion of the issues and could potentially get into personal views (the modalities are being finalised).
Mixed news in the CPI data
A final data-related point is that MPC have also likely been reassured by the fall in the proportion of the CPI basket in deflation apparent when you dig into the entrails of Tuesday’s CPI release (the February IR identified this as a key indicator of whether a deflationary mindset was taking hold).
Counterbalancing that, however, core CPI again undershot market expectations – for the fifth month in a row and nine of the last twelve months. And as I discussed in my 2 July blog there looks to be a reasonable, albeit far from perfect, correlation between GBP TWI strength (weakness) and negative (positive) core CPI surprises – consistent with the market underestimating the impact of GBP movements on core inflation. And, as discussed above, BoE work suggests that GBP moves have protracted impacts on core CPI inflation. So this continues to be a development to keep an eye on.