Carney’s forward guidance fails to impress

Tom Stevenson, Fidelity, 7 August 2013

Shares slide after new Bank of England governor unveils more transparent interest rate policy.

New Bank of England governor Mark Carney has certainly hit the ground running. Within weeks of arriving in London he had intervened to ensure that Jane Austen should be the face of the new ten pound note. Today, rather more importantly, he set out a new, transparent rate-setting framework designed to give companies and individual borrowers alike much more clarity about where interest rates are heading.

At the heart of the new approach is an explicit link between monetary policy and the unemployment rate, which effectively gives the Bank of England a dual mandate for the first time. Previously, its principal focus has been on controlling inflation. Now it will also pay attention to growth as indicated by the jobless rate.

Specifically, Dr Carney said that interest rates would stay at rock bottom until unemployment falls below 7%, which doesn’t sound much lower than today’s 7.8% but might not be reached for another three years according to the Bank’s own forecasts.

On the face of it, that promise of low rates for longer should have been welcomed by equity investors but the FTSE 100 actually fell quite sharply after the Bank press conference. The reason is that this simple measure was heavily hedged around with so-called “knock-outs”, effectively get-out clauses that would allow the Bank to move on interest rates even if the unemployment threshold has not been reached.

The first of these is if the Bank thinks that inflation will rise to more than 2.5% over a two-year time horizon. The second is if it believes that inflation expectations are spinning out of control – “not sufficiently well anchored” in Bank-speak. The third is if the Bank decides that current policy poses a threat to financial stability.

In other words, it’s forward guidance with some pretty big ifs. And to an extent that undermines the whole point of the exercise, which is to create certainty. There are still plenty of unknowns.

The other reason why shares fell after Dr Carney had spoken was his downbeat assessment of the economic outlook. A whole string of positive data announcements recently have pointed to a better than expected recovery in the UK economy. But the new Canadian Bank governor takes a rather more gloomy view of the UK than recent Boom Britain headlines might suggest.

He said that unemployment would not fall below 7% until 2016 and he reminded us that economic output remains 3% below its peak. Despite the rise in house prices recently, Dr Carney focused on mortgage approvals, which remain well below the long-term average.

That’s all in marked contrast to a whole host of positive readings in the last few weeks on consumer confidence, house prices, service sector activity, higher factory output, stronger bank profits and a doubling in the rate of GDP growth between the first and second quarters of the year.

When you consider that it is only a few weeks ago that the prospect of a triple dip recession was on everyone’s minds, this is a remarkable change in sentiment that has had a galvanizing effect on the stock market over the past six weeks or so. Dr Carney’s thoughts have poured a bucket of cold water on that brighter outlook.

For investors, today’s setback means that yet again the FTSE 100 has approached the all-time high of 6,930 before falling back again. That level has acted as a glass ceiling for shares for 13 years now, with two failed attempts to clear 7,000 in 2000 and again in 2007. If Goldman Sachs’s forecast of 7,500 for the UK benchmark within a year is to be achieved the FTSE 100 is going to have to shatter the glass.

Will it be third time lucky? Dr Carney’s low interest rate environment for the foreseeable future will certainly be helpful. If that is combined with a brighter outlook than he is factoring in then this might be the breakthrough moment. After more than a decade, it seems almost too much to hope for. 

Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions in this column are the author's own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and the figures and returns in this article are purely to illustrate the author's points.

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