The timing of Mark Carney's arrival at the Bank of England has proved most fortunate. Since he took the reins at the Bank in July growth has accelerated, inflation has dropped like a stone and the economy has created over a quarter of a million new jobs. The UK is now being talked of as the fastest growing economy in Europe.
The Bank, like everyone else, has been caught out by the pace of the recovery. In August, the Bank expected the unemployment rate to stay above 7.0% until the second half of 2016. Since then unemployment has dropped sharply, to just 7.1% in the three months to November. It seems almost certain to fall below 7.0% in the coming months, two-and-a-half years ahead of the Bank's August forecast.
In economics, every silver lining has a cloud. A recovering economy has fuelled speculation that the Bank could tighten monetary policy sooner rather than later. Media and market speculation has focussed on the timing of interest rate rises but there are other ways in which the Bank could tighten policy. This week we assess each of the three tools at the Bank's disposal and consider the order in which they may be deployed.
One of the big policy innovations to come in the wake of the financial crisis was the creation of the Financial Policy Committee at the Bank of England. The FPC, chaired by Mr Carney, is charged with safeguarding financial stability, a role in which most central banks have conspicuously failed in recent years. Whereas the Bank's Monetary Policy Committee works through interest rates and quantitative easing, the FPC can operate directly on the supply and price of credit. A wide variety of tools are at its disposal, including the power to alter loan-to-value ratios and reserve requirements or capital buffers for lenders.
This type of so-called macro-prudential regulation has been used in recent years by central banks in emerging economies to dampen overheating housing markets. Adjusting the effective cost to banks of providing mortgages is the principal means by which the Hong Kong authorities seek to control property prices. Similar policies were used in the UK between the 1950s and the 1970s. These controls were discarded by Mrs Thatcher's government in the 1980s. It saw them as an unwarranted interference in the market and increasingly ineffective in the face of financial innovation and globalisatisation.
The recovery in the UK housing market poses one very familiar, potential risk to financial stability. Mortgage lending has risen by over 30% in the last year and, according to Nationwide, house prices increased by 8.4% in the year to December. The Bank of England's decision to withdraw support for mortgage lending from the Bank's Funding for Lending Scheme last November showed that the Bank felt it had done enough to get the housing market moving.
Last week, analysts at Deutsche Bank suggested that the Financial Policy Committee might follow Switzerland's recent decision to increase capital requirements for banks providing mortgages. Such a policy would tend to increase the costs of mortgages and reduce their availability.
Our hunch is that the earliest tightening in the UK may well come this year in the form of a tightening of requirements around credit or mortgage lending. Indeed, in its latest meeting in November, the FPC discussed possible policy actions to mitigate risks from the housing market boosted by the government's Funding for Lending and Help to Buy schemes.
The second and most talked-about instrument at the Bank's disposal is the base rate. Last week, in what looked like an attempt to dampen expectations of early interest rate rises, Mr Carney effectively scrapped the link between unemployment and interest rates, emphasising that the UK economy has not achieved "escape velocity". The Bank seems to regard a long awaited recovery in capital spending and improvements in real incomes as essential conditions for a sustained recovery.
The good news for the Bank is that stronger growth has been accompanied by lower inflation. When Mr Carney introduced forward guidance last August, the Bank expected CPI inflation to be running at 2.8% at the end of 2013. The actual rate is 2.0%. Low inflation clearly reduces the pressure on the Bank to raise interest rates.
Financial markets are currently working on the basis that the Bank will raise rates in the first quarter of 2015 although speculation that it could be earlier has increased. Citigroup recently brought forward its forecast for a rate rise to the fourth quarter of this year.
The final weapon in the Bank's armoury is the unwinding of quantitative easing through the sale of its £375bn stock of UK government bonds. QE was designed to reduce interest rates, bolster risk appetite and increase liquidity and its unwinding could reasonably be expected to have the opposite effects. Certainly with the Bank's holdings of bonds accounting for around a third of the entire stock of gilts the effects could be significant.
Mr Carney seems in no hurry to unwind QE. In his first appearance before the House of Lords' Economics Committee, Mr Carney surprised many by saying that the Bank would consider raising interest rates before unwinding QE. He argues that it "would be most prudent to begin [the process of monetary tightening] with the conventional instrument" whose effects are well studied – i.e. by raising rates.
Our guess is that the first tightening of monetary policy is likely to come this year, probably through some sort of tightening of requirements around credit or mortgage lending. For now, we see UK interest rates rising in early 2015, before next May's General Election. The unwinding of QE is likely to start later, perhaps not until 2016.
Speculation about the form and timing of monetary tightening should not obscure the very good news that the economy seems to be on the mend. The worst thing would be if monetary policy were to stay on its current, ultra-loose settings – for that would signal that the economy is broken.
MARKETS & NEWS
UK's FTSE 100 ended the week down -2.4% over fears about China's economy and the Argentinian peso's devaluation.
Here are some recent news stories that caught our eye as reflecting key economic themes:
KEY THEMES
- The Argentinian peso fell to a record low, with Argentinians seeking to buy dollars as protection against soaring Argentinian inflation
- Activity in China`s factory sector contracted in January for the first time in 6 months, according to purchasing managers data from HSBC/Markit
- UK unemployment fell to its lowest level for almost 5 years, with the number of jobless falling by 167,000 in the 3 months to November
- A London based property developer secured the world's largest peer-to-peer loan, raising £4m through online platform LendInvest for a residential housing project in Croydon, south London
- The UK's online retail economy generated an estimated trade surplus of £720m in 2013 according to research by OC&C Strategy Consultants/Google
- The recently-privatised Royal Mail said it delivered the equivalent of 417,000 parcels every hour on December 18th, benefitting from the boom in online shopping
- Estimates from HM Revenue & Customs indicate that exports of textiles from Scotland to China are about to hit a record high, with strong Chinese demand for tweed clothing in particular
- Google struck a deal to buy all of the electricity generated by 4 Swedish wind farms over a 10 year period, following other recent investments in solar plants and wind farms
- Discount retailer Poundland announced record Christmas sales, with sales up 12.4% in three months to 31st December
- Capital spending by US companies is expected to grow this year at its slowest pace for 4 years, according to a consensus of analysts' forecasts
- Optimism in the financial services sector rose at its fastest rate since 1989 in Q4 2013, according to survey data from the CBI and PwC
- Investor Carl Icahn increased his total holding in Apple Inc. to $3.6bn, or around 0.7% of the company's $500bn market capitalisation
- The Mexican economy has secured new investments totalling more than $7.35bn from PepsiCo, Nestlé and Cisco, following a series of economic reforms
- US natural gas futures rose to their highest level since August 2010, with cold weather leading to a surge in demand for gas
- London-based auction house Christie's announced a 16% rise in sales in 2013, driven by a surge in first-time art buyers
- Consumer products company Proctor & Gamble cited the craze of growing moustaches and beards during the month of 'Movember' as a reason for declining razor sales – tashflow statement
Regards,
Ian
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