Despite encouraging comments by the IMF, Bank of England Governor, Carney, is right to be cautious about the ‘sugar rush’ recovery so far, and keep all his stimulus options on the table, argues Neil Williams (pictured), Chief Economist for Hermes’ Global Government & Inflation Bonds…
While the UK’s 0.7%qoq on Q2 GDP was its best for over two years and the G7’s joint fastest after Japan (0.9%), the UK still has the lowest base to spring back from.
Markets are so far giving the Monetary Policy Committee (MPC) the benefit of the doubt that inflation-control remains a primary aim, but this could change. Marrying ‘forward guidance’ on Bank rate with a +2% CPI target deferred to the end of 2015 will increasingly worry some that they’re subordinating inflation-control to growth considerations. Early nerves have been evidenced by a rise in long gilt yields, and the bringing forward to 2014 of expectations for the first rate hike. This looks too pessimistic.
The experiment will be interesting, and it remains to be seen whether guidance ends up giving an added impetus to growth. Stripping out the unemployment rate, which is a puzzle, and the ‘knock outs, ’which are judgement calls, surely gets us back to the past five years’ ‘flexible CPI targeting’.
Dr Carney’s starting point is encouraging. The past months’ economic data have strengthened - both on the demand (e.g. retail sales) and supply (manufacturing, services, construction) sides. After four years of stimulus, improvement was inevitable. Yet, it’s too soon for complacency.
First, despite rising GDP, the UK remains in the ‘slow lane’ of global recovery. With its GDP still 3½% down on its pre-crisis level, the UK is half way to a ‘lost decade’. Inventories are building, meaning less future production, and capex, typically led by certainty about demand, was down 2.7%qoq in Q2.
Second, the euro-zone remains a threat. Greece wants another EUR3-4bn, Cyprus’ terms need reviewing, and Portugal will have to extend its bail-out beyond mid 2014. The ‘bill-payers’ (e.g. France) are strained. So, restructuring risk is not removed, no matter how punctuated the recession, or imminent Merkel’s coalition.
Critically, third, it remains to be seen how much of the UK’s latest growth surge is linked more to housing, PPI payouts, and other temporary ‘feel-good’ factors, rather than something more durable.
There have been few better coincident indicators of UK growth than real house prices. These have, with government supports such as the FLS, and help-to-buy, crept back into positive territory. Despite regional disparities, low-rate guidance risks fuelling house price inflation, especially if a weaker pound and low rates elsewhere again garner international interest.
No major country since 2000 has net loosened its overall policy more than the UK. It’s no coincidence, given the inflation risk, that countries with the loosest policies generally suffer the softest currencies.
This suggests the pound could, as a second-round effect from loose policy, be a more potent channel to inflation than the QE itself.
One thing is sure: Carney will want to maximise the benefit to banks by keeping the gilts curve steep. Guidance should put weight on UK rates and short yields, but he needs to avoid an obfuscation of the Bank’s commitment to low inflation, if long yields are also to stay down. Otherwise, the MPC may ultimately have to draw more heavily on QE, deferring the time when it can ‘kick the drug’.
In short, growth should continue in the UK helped, but probably not caused, by the guidance we heard about in August. The Bank will carry on only ‘flexibly’ controlling CPI inflation and facilitating growth. Meantime, it’s over to the US to avoid default, and the chancellor to keep hitting the housing button, and worry about it after 2015.