Article / 14 July 2015 at 16:48 GMT

Carney presents the case for a rate rise, he is premature

Managing Partner / Spotlight Group
United Kingdom
  • Carney suggests a rate hike is still on the agenda
  • Why hike while inflation remains at zero?
  • Forward guidance is good but this is premature

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UK consumer prices aren't rising, so why hike interest rates? Photo: iStock 

By Stephen Pope

Bank of England (BoE) governor Mark Carney has suggested that central bank officials are edging closer to tightening policy as the economic recovery continues.

Addressing a parliamentary hearing in London this morning, he said:

“The point at which interest rates may begin to rise is moving closer given the performance of the economy … This is counterbalanced somewhat by disinflation.”

I believe the case for raising rates in the UK is not justified at the current time. On one hand it could be argued that GDP growth and business capacity utilisation is looking relatively healthy. See these first two charts.
UK GDP

Source: Office For National Statistics 
UK Cap Ut  Source: ECFIN 

However, the only reason to raise rates at the current time would be if inflation were gathering a head of steam. This is not the case, as in June 2015 consumer price inflation was flat, i.e. 0.0%. Indeed inflation has been on a steady downward track since it was at 5.2% in September 2011.

If one looks at the record of Mark Carney on keeping inflation close to the 2.0% target set by the Chancellor of the Exchequer then one could hardly say it has been a roaring success.

Under the BoE remit, if inflation strays more than one percentage point in either direction from the 2.0% target the Governor must write to the Chancellor explaining why inflation is off target and what the central bank intends to do about it. Before Mark Carney arrived all of the 14 letters written had been after inflation missed the target too far on the upside, i.e., running at 3.0% or more.
UK Inflation
Source: Office for National Statistics

Carney Source: Spotlight Ideas

As one can see over the course of the 24 months that data has been released whilst Mark Carney has been the BoE governor there have been seven letters submitted or scheduled for submission to the chancellor, i.e. 29.2% of the time he has been in office.

In contrast, in the 16 years or 192 months of BoE independence before Mark Carney arrived there were just 14 letters sent to the Chancellor. That is a percentage rate of just 7.29%.

Focus on labour markets

The argument from the BoE and the Monetary Policy Committee is that the focus has to be on the labour market as a gain in wage rates has been assessed as worrying.

The unemployment rate in the UK remained unchanged at 5.50% in April 2015 from 5.50% in March 2015. Unemployment in the UK averaged 7.23% from 1971 until 2015 (Source: Office for National Statistics or ONS). Wage growth in the UK increased 2.70% in April 2015 over the same month in the previous year.

The price and wage behaviour described in theoretical macroeconomics suggest that long-run movements in wages and prices must be related, however past empirical analysis of the relationship between wages and prices within the expectations-augmented Phillips curve model has raised doubts about the effects of labour costs on inflation. 

In the case of the UK I have regressed wage growth against inflation on a basis of even dates, then inflation lagged by three, six and twelve months. I have not found the correlations very compelling as the respective levels of R-Squared are:

0.1946…0.2344…0.2314…0.1351
Source: Office for National Statistics

One can see that wages are beginning to grow and yet from the chart the only time when wage growth has led to a lagged rise in inflation is that market by the rectangles (above). This embraces wages from February 2009 to August 2011 and inflation from September 2009 to October 2011. That would be roughly equal to a two or six month lag and as we have seen above, the correlation is barely above 20%.

Of course the base rate is low – historically low – and most right-minded households are not looking for rates to be fixed at 0.5% forever. In fact, the evidence will show that expectations for the first interest rate increase is at May 2016 and that people’s inflation expectations are well anchored for the next two to three years.

I know that governor Carney is a proponent of forward guidance, however, in this instance I do believe he has blown the bugle rather earlier than is necessary given the extremely tepid outlook for inflation.

– Edited by Clare MacCarthy

Stephen Pope is managing partner at Spotlight Ideas
4y
vanita vanita
Sir Stephen,
Sir you are still bullish on Dax against cac40.
As Dax is not moving faster den cac40.
So what's ur advice on this trade.
Thanks Steve.

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