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Is Carney playing for time?

Bank of England Governor Mark Carney has been toying with investors’ emotions for so long that markets really should be used to it by now, Rathbones head of fixed income Bryn Jones argues.

Like an unreliable boyfriend, Bank of England Governor Mark Carney is all talk and no action.

In the immortal words of Labour MP Pat McFadden from 2014, he’s hot, then cold, and investors don’t know where they stand.

Mr Carney’s latest monetary policy statement was much more aggressive than we have seen for some time and it sent gilt markets and their derivatives staggering. Essentially, he said the UK economy was doing better than expected and that employment conditions were bright. His conclusion was that if the current environment persisted the bank would need to tighten monetary policy faster than the market expects.

We agree that the market has been expecting steady interest rates to continue much longer than seemed likely, yet now seems an odd time to cheer the state of the British economy. We have been a little dubious of Mr Carney’s credibility for some years now and this latest episode seems just another example of his bank jumping from hawkishness to dovishness and back again.

Still, like a desperate suitor, the gilt market keeps listening to him.

Following the Brexit vote, the UK economy was actually humming along ok. But Mr Carney halved the benchmark interest rate to 0.25%, restarted quantitative easing (QE) and put up £100bn of cheap funding for banks. It’s true that the vote caused much uncertainty, but the amount of stimulus Mr Carney injected into the financial system was extraordinary.

He continued to be cautious and brooding about the potential for a downturn, despite generally positive data and little sign of financial dislocation or corporate unrest.

Because of this, investors decided that UK interest rates wouldn’t rise till at least the first quarter of 2019. Well, that’s what buying and selling on the swaps markets implied anyway. We felt that was way too pessimistic – so did many other people – but that’s what the weight of money said.

Now, after months of worry and warnings, Mr Carney abruptly changed his tune. But, strangely, at a time when economic data are actually looking a bit wobbly. Markets responded with the financial equivalent of a handbrake turn. Now, instead of expecting a 0.25% rate hike in 15 to 18 months, the next rate rise is forecast for December this year.

Even if this 25-basis-point rise goes ahead, the UK’s monetary policy will remain much looser – and supportive to the economy – than it was before the Brexit vote. That’s because of the continuing effects of QE and the roughly 11% fall in sterling since the referendum, which is similar in effect to a fall in interest rates. A good thing too, as economic growth has dipped lately and real wages are still badly squeezed which is hurting consumption.

It could be that Mr Carney is talking tough in an attempt to bolster sterling. The currency weakness, while helpful for monetary conditions, has been spurring inflation higher, eating into the purchasing power of UK consumers.

At writing, CPI was 2.9%, while RPI was almost 4%. The BoE is in a bind: it needs to keep rates low to avoid strangling modest GDP growth but inflation has been above its 2% target for seven months and counting.

Our head of asset allocation research, Ed Smith, has been investigating how inflation is likely to be affected by demographics, globalisation and technological progress over the longer term. We will be publishing a report on his findings in the next month or so.

As for what will happen over the next year or so, we believe inflation should peak this quarter. The domestic inflationary pressures that the BoE follows are levelling off, significantly greater jobs growth is likely to be stifled by skill mismatches, while those jobs where the supply of labour is tightest are in typically low-paying industries. This will be good for income inequality figures, but it is unlikely to push the headline average wage higher.

The question is: does Mr Carney need to curtail inflation more than he needs to support economic growth? We think the answer is no. History shows the BoE usually errs on the side of caution with its interest rate policy, and we see no reason why this time should be any different.

Investors should probably spend less time fretting over Mr Carney’s harsh words. He’s probably just playing for time.

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