The Bank of England (BOE) took the unconventional step of issuing a statement accompanying its rate decision, despite there being no change in monetary policy. As this was Mark Carney’s first rate-setting meeting, this was not completely unexpected but the inclusion of wording stating that “the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy” led to a re-pricing of interest rate expectations downwards.
This was swiftly followed by the European Central Bank (ECB), where Mario Draghi stated in his press conference that “the key ECB interest rates will remain at present or lower levels for an extended period of time”. This statement left the door open for further cuts in the main refinancing rate, as well as the possibility of moving deposit rates to negative levels. This also led to a reappraisal of the likely path of interest rates downwards.
It is clear that the BOE and ECB were concerned about the impact of the US Federal Reserve’s communication on expectations within their own markets and have attempted to lean against these moves. Whilst the US economy appears to be on a firmer footing, with a more durable recovery in housing and solid employment gains leading to increased confidence in the economy, the BOE and ECB both feel that it is too soon for their respective markets to be pricing in a normalisation of rates. We believe that it is increasingly clear that there will be a divergence of policy rates between the US and Europe, similar to what we experienced in 2004-05. The central banks have employed rate guidance to ensure that the market pricing reflects that.
Our view on rate guidance is that whilst it can influence market pricing to some extent, faith in its ability to significantly influence market pricing over and above existing practices is misplaced. In the UK, the market has historically always been able to use the Quarterly Inflation Report, through the publication of its forecast of inflation, as a guide to what the expected path of interest rates should be. Going forward, this message is likely to be more explicit, but without having a greater influence on what path of interest rates is priced in. The US has experimented with two forms of rate guidance. First, it employed “time-contingent” guidance, implying rates were unlikely to rise before a stated point in time. It then shifted to using “state-contingent” guidance, stating rates were unlikely to rise until thresholds around unemployment and inflation were met.
Whilst time-contingent guidance can influence pricing over the short term, the market is unlikely to trust any guidance that extends past two years. This is because the economy is simply too difficult to predict with great accuracy beyond two years so it is hard to know with certainty what the appropriate path of interest rates will be. If the UK Monetary Policy Committee decided alternatively to use state-contingent guidance, the market is likely to change the expected path of interest rates as new data about the economy is released. Such a move would be unlikely to reduce the volatility of what is priced in to the market. With no interest rates rises priced in for at least two years in the UK, absent of any rate cuts, we view it as unlikely that interest rates between the 2 and 5 year part of the yield curve will fall materially further. Signs that the UK economy is improving, coupled with a strengthening global backdrop, mean that should the economy gain further momentum, rates may in fact go up sooner than the market currently expects.