Mark Carney, Governor of the Bank of England, spoke yesterday to try to convince markets that interest rates will stay lower for longer than they expect. Assuming that was the intention, it wasn’t very succesful.
Why don’t markets share the expectations of Governor Carney and the MPC? There are many possibilities. Some possibilities Carney dealt with in his speech, but not all.
1) Markets don’t believe that the economy will pan out the way the MPC think it will. For example, they may not buy the analysis in the Inflation Report that the heating up of demand indicators over the last 3 months or so was precisely matched by an expansion of supply capacity, and therefore won’t affect the outlook for inflation. Or perhaps they don’t believe that the natural rate of unemployment is as low as the MPC thinks it is, and so they guess that the ‘inflation knockout’ will ‘knockout’ the commitment. Some participants in the market might (like me) put weight on the event that the stability of inflation itself over the last several years is evidence that the unemployment rate is closer to its natural rate than MPC appear to believe. Or, perhaps markets are unnerved by MPC’s silence on the topic of how they have grappled with issue of how to estimate the impact of a very prolonged period of fixed interest rates? As pointed out in previous posts (and before that by other writers) the MPC’s model (like all those it descended from) is extremely unreliable in this regard, and so the MPC is forced more than usual to rely on guesswork.
Unfortunately, Carney didn’t do much to try to address this problem. He did re-emphasise that 7% was a ‘staging post’ not a trigger, in case that was the source of the disagreement. He also noted that pre-crisis unemployment rates fell to 5%, hinting that the natural rate may be much lower than the staging post of 7%. But that period may have simply been an unustainable low; and post crisis, after long-term unemployment has entrenched itself, the natural rate could be much higher. If you think markets are overestimating the natural rate, it is pretty unpersuasive simply to point to these pre-crisis rates. MPC could start by telling us what they think the natural rate is, or will be, rather than keeping us guessing. And in general they could be greatly more transparent about the model and judgements that construct the forecast, so that participants can take it to pieces and reassemble, getting a better sense of where MPC are coming from. The August Inflation Report took steps in that regard (a fan chart for unemployment, for example), but only baby steps. There are some reasons to keep back information. MPC might worry that in the hands of mischievous or ignorant outsiders (like me) this information would be put to nefarious or damaging uses. But the cost is that some suspect that the reason for not being clearer is to create wiggle room for future changes of policy: wiggle-room that can be used to disguise a change of mind as consistent with the commitment already made.
2) A second reason why markets don’t share MPC’s forecast for future rates is that they don’t believe that the MPC believes its own forecast. (Governor Carney didn’t cover this reason in his speech!) What do I mean by that? Surely the MPC wouldn’t publish a forecast it didn’t believe in? What I mean is that the MPC is a heterogenous committee of 9 persons, and the mapping from the views of those 9 persons and the one published forecast is completely opaque. (And has been since the Halcyon days of ‘Table 6b’, where the separate forecasts of Wadwhani/Julius/Allsopp were recorded). Up to the point where the forward guidance was announced, there was a clear division of views between those who wanted to inject more stimulus, and those who did not. This was reflected in some difference of view about how variables the MPC cared about would evolve under different paths for interest rates and asset purchases. It’s not clear how those two (if it is only two) sets of forecasts have changed since Carney’s arrival, and therefore not clear what to make of the collective forecast published in August. Perhaps markets put some weight on this disagreement persisting, hidden from view in the collective, ambiguously weighted Inflation Report projection, but likely to resurface and make itself felt later.
Carney didn’t do much to illuminate us on this, and neither did the minutes of the August MPC meeting. Before the agreement on forward guidance was struck, the first forecast round for the MPC was looking from the outside like a car-crash. Carney had made public remarks before taking office that he believed in FG, because it provided a way of injecting extra stimulus, yet the majority of the MPC not only presumably did not support FG (otherwise why their silence or disapproval on the subject up to that point) but didn’t want more stimulus. Magically, agreement was struck. Carney described FG as making monetary policy ‘more effective’ at the Inflation Report press conference, careful not to say ‘more stimulatory’, but actually drawing a distinction without a difference. The hawks so far register no protest, so perhaps for them it is a distinction with a difference.
What are markets to make of this? The magic that might unite the MPC behind the need for more stimulus could be the unwanted tightening of the yield curve around the time the first talk of ‘tapering’ emerged from the Fed, combined with the view that the distinct warming of the data at the same time was inflation-neutral (as remarked above, conveniently accompanied by an exactly matching improvement in supply). But this stretches credulity for me, and perhaps for markets too. For one thing, there have been many wiggles in the yield curve in the life of MPC, but none seem to have so decisively altered the consensus on MPC about the stance of current policy as this one. For another, if this was what swung the hawks into line, why has there not been a clear focus on explaining and articulating it? This is surely THE key conundrum about recent MPC behaviour, but it scarcely receives a mention. It’s as if MPC wiped the slate clean and started over, pretending that all differences in view had evaporated. Hence I called it Fudged Guidance. For some, a plausible interpretation is that the hawks simply decided to set aside their independent vote for a while, as a kind of golden hello to the new Governor. Many in the media write as if the Governor is the Committee (just as he was in Canada), ignoring the painstaking attention to individual accountability that MPC members give. By not paying more attention to the task of articulating whether the course has changed, and, if so, why, MPC are naively running the risk of fuelling this lay view of a committee dominated by its charismatic new chair.
Not adequately explaining past changes of course is particularly hazardous in the new game MPC is playing. The whole point of forward guidance is to convince observers that there will be no such changes of course in the future, thus influencing expectations now, thus generating more stimulus now. So to start out on forward guidance by appearing to change course inexplicably is not only ironic but potentially self-defeating.
3) This leads me to mention (again) the third obvious possibility. Even if markets believed that the MPC were united in their views about the economy, they don’t believe that MPC will necessarily follow through with forward guidance. I and many others have written about this before, but forward guidance is bluff, inherently non-credible. Once the stimulus from lower expected future rates is pocketed, there is every incentive to renege and tighten. The MPC turns over slowly, after all, so the agreement struck now could easily be set aside if newer members don’t concur. The cost is that MPC has egg on its face. But the benefit might be preventing another asset price bubble and ensuing bust. This would come back to haunt MPC if there were another zero bound episode, but, what the hell, perhaps the calculation is that there won’t be another one until everyone has forgotten?