'Firmly challenged': Markets are ready to call the Bank of England's bluff

  • Bank of England Monetary Policy Committee set to leave rates and QE unchanged.
  • Rhetoric from the central bank is set to take a hawkish tilt and warn on rate rises.
  • Thursday will be a test of the Bank of England’s credibility, with markets sceptical that the MPC has room to increase interest rates.

LONDON — The Bank of England faces a test of its credibility, and market reaction its monetary policy announcement on Thursday will indicate just how seriously investors take take the central bank.

Policy is almost guaranteed to remain unchanged, with interest rates at a record-low 0.25% and the bank’s bond-buying programme capped at a maximum of £435 billion overall.

What is expected to change, however, is the tone taken by the central bank, as it tries to prepare the markets, and the wider British public, for the possibility of interest rate hikes in the near future as the key policy trade-off the bank has to address shifts direction.

At its simplest level, the policy dilemma facing Britain’s central bank is that it must balance surging inflation brought on by the weakened pound since the referendum, with the slowdown in the economy, dwindling consumer spending and declining inward investment.

So far, the weak economy has largely held sway on the MPC, with the closest vote held since the Brexit seeing three members of the committee backing an increase in rates back to 0.5%, and five voting to leave rates unchanged.

But inflation is running at 2.9% — almost an entire percentage point above the bank’s government mandated target — and wage growth failing to keep up with the rising price of goods, so talk of an interest hike to squash inflation is growing.

“We believe that BoE officials may use the policy statement, accompanying minutes and vote split this week to try and shake up market expectations for the path of policy,” ING FX strategist Viraj Patel wrote this week.

A hike is very unlikely happen this month, but it could happen a lot sooner than the end of 2018, where market expectations currently sit.

“Based on the UK OIS curve, implied market pricing suggests that there is a barely one in four chance of a 25bp Bank rate increase this year, which rises to only a 65% probability by the end of 2018,” Patel adds.

The bank is trying to prepare the markets for an interest hike sooner than currently expected, but the markets are simply not buying it, assessing the economy as too weak to be able to absorb rising interest rates.

“Hawkish rhetoric by BoE policymakers will be firmly challenged as repeated statements by MPC members that rates will have to be increased faster than the market currently expect have been continuously discounted,” Fabrice Montagne of Barclays wrote in a recent note.

That’s down to a series of perceived changes of heart from the bank’s policymakers in which they have said one thing, and done another. Most recently, Chief Economist Andy Haldane pretty much guaranteed that he would vote for an interest rate hike at some time in the summer, but then when the bank’s August meeting came around, he voted to leave rates unchanged.

This isn’t the first time the bank has faced scepticism. Governor Mark Carney’s much discussed policy of “forward guidance” — introduced in 2013 and designed to explicitly telegraph future policy intentions — came under heavy criticism in the pre-Brexit era as bank actions often contradicted the words of both Carney and other MPC members.

Soon after Carney became governor in 2013, the bank famously said it would not consider raising interest rates before unemployment dropped below 7%. At the time unemployment was close to 8% and the bank believed that it would take as long as three years to achieve. Employment promptly fell to 6.9% by February 2014, less than seven months after Carney’s guidance. It is now down to 4.3%.

The bank did not raise rates, and Carney was dubbed an “unreliable boyfriend” by MP and Treasury Select Committee member Pat McFadden in June 2014.

“One day hot, one day cold, and the people on the other side of the message are left not really knowing where they stand,” McFadden said in a now famous exchange at a TSC hearing.

Those earlier experiences of monetary policy guidance under the governorship of Carney are likely to be having at least some impact on the current perspective of markets when slightly mistrusting the bank’s words.

The Brexit uncertainty issue

Brexit undeniably has a huge role to play in any Bank of England decision, with Deutsche Bank’s analysts arguing that the bank will not move on rates until the outcome of Brexit is more clear.

“We continue to expect the BoE to remain on hold until uncertainty about the Brexit transition diminishes. Too many aspects of the policy trade-off hinge on the outcome,” Deutsche’s team of Oliver Harvey and Mark Wall argue.

That’s a view echoed by James Knightley at ING, who says that looking at Brexit talks alongside slowing GDP growth and continuing spare capacity in the economy means that the bank won’t make any changes for a little while yet.

“Add in the Brexit-related uncertainty, which won’t fade anytime soon given the noises coming from London and Brussels and it seems to us that the most likely path for central bank policy is one of stable interest rates,” he wrote on Tuesday.

Central banks have twin powers. One is the ability manage the economy through raising or lowering interest rates or quantitative easing, backed by political independence.

The other is to manage markets’ expectations through the carefully chosen wording of its policy announcements, which is backed by its credibility. If the bank were to lose credibility, it would weaken this power.

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