On the first Thursday of every month the BoE announces the base interest rate, and has historically only provided a statement with the announcement if there was a change to the rate, or as has been the case more recently, if there has been amendment to the size of QE or other changes in policy. This month, for the first time there was a statement released despite there being no change in policy as the BoE prepared the UK and the markets for the start of forward guidance. Forward guidance is when central banks indicate potential future monetary policy with reference to their projections for the economy. This is in contrast to how the BoE (and many other central banks including the ECB) has previously operated in purely announcing the policy decisions for that month with no future indications of when rates may change or QE may end (or whether in fact it may increase).
There has been a lot of debate in the markets and the media over the positive and negative effects of having a forward guidance. Criticisms have included the fear that if the predictions made turn out to be inaccurate then the credibility of the central bank is put at risk, with investors losing trust in their ability to have an impact on the economy. Other worries are that statements could be misinterpreted by the markets causing damaging asset movements, such as pushing up the bond yields in a country, which ultimately could have a negative impact on the economy. This, ultimately, could then lead to the banks projections failing to be fulfilled and thus leading to a credibility problem. I spoke about one of these previous market misinterpretations in the reaction to Bernanke's forward guidance in the post a couple of weeks ago whilst there was a similar misinterpretation (and sell off) when Australia's chief central banker attempted to introduce a bit of humour into the Reserve Bank of Australia's decision to keep rates the same.
There are more positive sides to having such a transparent and indicative process and I believe these outweigh the potential risks. In most walks of life it is fair to say that communication and how things are communicated can be a crucial difference between success and failure. By giving the market an indication of how they believe the economy is likely to perform in the next couple of years, and giving guidance as to the use of the tools being considered over that period gives the markets a clarity which should only assist them in their forward thinking. The uncertainty as to what a central bank might do has often had drastic consequences on assets which in itself have caused a damaging effect on the economy and potentially led to central banks acting in a manner which they had not previously planned to do. Removing this uncertainty should hopefully remove such potential volatile reactions.
This is becoming increasingly important now for the BoE as there begins to be a divergence in the performance of the US economy with that of the other economies. Previously the markets have been able to work on the assumption that the US, EU and UK are all working in the same direction and that all their central banks will continue with loose monetary policy in order to assist in getting their respective economies out of the doldrums. Now, with the Feds most recent announcement (using forward guidance) that they could consider stopping QE in the US, should the economy recover as they expect it to, it is important for the other central banks to provide clarity to their own positions with similar transparency. UK Gilt Yields had seen a similar rise to their US counterparts following Ben Bernanke's speech indicated to the markets that there was a risk of rising interest rates in the future. This despite there being no indication that the UK was going to do the same. Mark Carney's first monthly rate decision statement thus quickly served to separate out the BoE's policy from the Fed stating "The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy." This served to ease the upward pressure on Gilt yields causing them to drop slightly off the back of the BoE drawing attention to the fact that the UK is in no current position to follow the example of the US and begin thinking about tighter monetary policy. The statement pointed to the fact that although "recovery is in train...it remains weak by historical standards and a degree of slack is expected to persist for some time." It was no coincidence that Mario Draghi of the ECB indicated they too would also look towards giving forward guidance in the future.
All of this should only be seen as only a positive step by investors and indeed by the media. What is important however is that the predictions given by the BoE (and ECB) are seen as purely that, predictions. Looking back at thing in hindsight by others is often the end for those who try to make accurate predictions for the future. The media especially are quick to pounce upon those in positions of power to remind them of what they predicted when it turns out differently. It is important to remember that the predictions are based on the data and projections available today and are purely used as a guidance as to what is perceived as the likely outcome, and how monetary policy will be reflected should that reality occur. That's why it is crucial that both the media and investors concentrate on what is actually said as opposed to what they want to try and interpret from the words (potentially for their own ends).
There was an interesting research paper posted by the ECB which I read at the weekend entitled "Loose Lips Sinking Markets". The paper found that the yield spread of both Irish and Greek sovereign bonds over the German bund at the height of the euro crisis (2009-2011) was affected by comments made by both national politicians and international actors, such as ECB board members. Moreover what was also discovered was that negative comments, even by relatively minor politicians, had a more damaging impact on the yield spread than the positive impact of upbeat comments. Mark Carney has arrived in the UK with many investors and indeed the media looking at him as being the savior with the ability to pull out all the tools necessary to help guide and shock the British economy back to prolonged and effective growth. However he only holds some of the tools. A big assistance in managing this also lies with the politicians. In the UK especially, fiscal policy is going to play an important factor in getting the UK back to health (more on this in another blog). As the aforementioned paper demonstrates, the words of politicians (on all sides of the political spectrum) in addition to those of the financial guardians could have crucial impact on not only the behavior of the markets, but also as a result the behavior of the economy. The media (and investors) also bear responsibility for ensuring that there is no overreaction to a slightly adverse economic indicator or indeed a flippant or point scoring comment from an opposition politician.
The last Canadian to arrive on these shores with such an expectation to bring back success to the UK ended up a US Open finalist, but ultimately couldn't go that final step of the way to bring cheer to the country. Greg Rusedski at the time was able to share that burden of expectation of the nation with Tim Henman, himself only capable of a string of semi-finals. Mark Carney will need to hope to share his burden with George Osbourne, for now at least. If I were to offer Mr. Carney some advice (in case he was looking for it), it is likely he will learn soon enough the UK media's love for building someone up to the top only to try and displace him in the cruelest way possible should they not be able to quickly provide the success required. I would hope this doesn't dissuade him from his efforts to provide more clarity and forward thinking for the way forward for monetary policy in the UK (He might also want to avoid using humour given it's consequences for his Aussie counterpart). As for being able to deal with the expectations of a nation being placed on one man's shoulders and succeeding, well I suggests he gives Andy Murray a call.
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