Mr Carney chose Nottingham, middle England, to make his first public speech since assuming the role of governor of the Bank of England. Nottingham at the heart of the country with it’s small & medium sized businesses represents the core of the British economy. His, was a message of reassurance and support for British industry, reassurance that interest rates will stay low until the economic recovery is well established.
Mr Carney felt the need to provide this reassurance because of the scepticism by some sections of the media and the actions of the financial markets that greeted his first attempt at forward guidance of monetary policy.
The MarketsYou will recall the financial markets had built up their dovish expectations in advance of Mr Carney’s speech on forward guidance on the 7th of August by lowering interest rates and selling the pound. In the event they were disappointed, interest rates immediately spiked higher & Sterling strengthened. So the Nottingham speech was seen by many as the perfect opportunity to reinforce the message that interest rates will stay low for a long period (until 2016), they also hoped that the caveats around inflation and the unemployment rate would be softened.
In fairness to the Governor he partly delivered, he said that 7% unemployment was not a target but a staging post. He commented that unemployment must fall to 7% before the Bank would consider putting up interest rates and it would be wrong to assume that they would automatically rise. He said that growth prospects for the next three years were solid but not stellar.
The markets reaction appears perverse, swap rates were driven lower in advance of the Governor’s speech but rose almost 8bp afterwards, Sterling was sold from .8550 to .8652 in the twenty four hours before hand but has since strengthened back to .8540 at the time of writing.
Why doesn’t anybody believe me?Swap rates have given up most of their gains but only as a reflection of more general weakness in global rates. Sterling as stated retains a bid tone. So why is this?
A possible explanation is that while Mr Carney has given comfort that if the unemployment rate hits 7% it does not mean an automatic tightening of monetary policy, he did not provide any ‘’get out of jail cards’’ in relation to inflation. So perhaps this is the real reason for the market’s scepticism concerning forward guidance and UK interest rates remaining low for a protracted period. The market simply does not believe the Bank’s inflation projections. Who can blame them? The Bank’s inflation beating credentials leave a lot to be desired yet that remains their central responsibility! Inflation has been above their 2% target for more than three years.
Inflation (Consumer Price Index EU Harmonized YoY) (Source: Bloomberg)
What does this mean for Sterling?The Market will focus on unemployment data but I think the inflation data will become even more important as time goes on. Sterling I believe in the short term will continue to range trade, with good buyers of Sterling between .8700 and .8750. The sellers of Sterling will appear firstly at .8470/80 and in greater numbers at .8380.
As the year progresses and as we enter 2014 it will become apparent if the Bank of England will hit it’s inflation target, I remain to be convinced that they will do so and because of this I can see Sterling heading for a test of .8000 against the Eur in early 2014. What might change my view? If the Bank of England gives some indication that they are prepared to tolerate higher inflation until the economic recovery is firmly established.