By Alastair Thomas, Head of Rates and Treasury Management at ECM
The central banks of the US, the FOMC or “Fed”, and the UK, the Bank of England (“BoE”) have tied their monetary policy to explicit unemployment levels as well as inflation. Since 1977 the Fed has had a dual mandate to target maximum employment as well as stable prices and moderate long-term interest rates. Only in December 2012 did they state a specific unemployment rate of 6.5% above which they would not raise rates so long as longer term inflation projections were not more than 2.5%. This was a change from their “date-based” guidance whereby they did not expect to raise rates before a certain date. In March 2013 the Fed had expected unemployment to be 6.7 to 7.0% in Q4 2014 and 6 to 6.5% in 2015. Fed Chairman Bernanke also stated in June 2013 that the Fed’s 6.5% target was a “threshold, not a trigger”. At that same time he also said that “when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%” although he subsequently backed away from this 7% figure in September as unemployment continued to fall. US unemployment hit 7.0% in November and 6.7% in December 2013. We expect it to continue to fall at the current pace as initial claims remain very low and reach 6.5% this autumn.
The BoE is mandated to target CPI inflation of 2%. In August 2013, the BoE introduced its own unemployment threshold of 7.0% above which it would not raise rates so long as inflation expectations were anchored. Just like the Fed they have emphasised that the level would not be a trigger for rate rises but one where they consider more carefully whether rate rises are warranted. In August 2013 the BoE expected unemployment only to drop to 7% in 3Q 2016. I commented back then that their forecasts looked extremely dubious as they showed 7.3% being hit by the end of 2014 and then only another 0.3% drop in the following 2 years. In their November quarterly inflation report the BoE revised their forecasts substantially indicating the 7% level would be reached in Q3 2015 with a 40% chance of reaching it by the end of 2014. In reality unemployment has fallen more rapidly just as we predicted and is already at 7.4% and likely to hit 7.0% before the year-end.
The logic of linking monetary policy to unemployment is that falling unemployment is indicative of a reduction in the level of spare capacity in the economy. If spare capacity is reducing employers may need to hire more staff and pay more to get the employees they want, leading to overall wage growth which is likely to feed into higher prices generally. Since the central banks want to limit excessive inflation they use interest rate rises and/or remove provisions of liquidity (such as QE) which might otherwise fuel inflation.
The problem is that if declines in unemployment do not result in wage growth, perhaps because workers are happy to have a job and not push for pay rises or the unemployment rate has only fallen due to a shrinking workforce, then the central banks might decide they had set the unemployment “thresholds” too high. They would not want to be accused of killing off economic recovery by raising rates or removing other accommodative policies prematurely. As our co-CIO Ross Pamphilon mentioned in his commentary in early December we expected the Fed to “strengthen” their forward guidance on rates to reduce the risk that the fall in unemployment would result in increased rate expectations. Shortly after Ross’ suggestion, the Fed said that it will likely be appropriate to maintain the current Fed funds target range (of 0 to 0.25% where it has been since December 2008) well past the time that the unemployment rate declines below 6.5% especially if projected inflation remains below their 2% longer-run goal. However, the Fed also clearly states that, because monetary policy affects the economy with a lag, it will be necessary to begin moving away from a highly accommodative policy before the economy reaches maximum employment (which they see as between 5.2 and 5.8%). This is probably why they also announced in December that they would reduce quantitative easing (“QE”) by $10bn in January – the start of the removal of accommodative policies. The minutes show that “most” officials want to taper QE at a “modest” pace and finish QE in the second half of 2014. The minutes show that the Fed had little desire to change the unemployment threshold as some had expected or change the inflation thresholds. We expect a further $10 billion of QE tapering each month with QE finishing before the year end. The removal of the large treasury purchaser will pressure longer rates higher.
It is possible that the BoE will follow suit and amend their forward guidance, possibly by lowering the unemployment threshold to 6.5% using the excuse of the recent fall in inflation (back to the 2% target after 48 consecutive months above it). As can be seen in the chart UK unemployment has not differed hugely from US unemployment in more normal times so arguably the BoE set the threshold too high. However, if they change it now, just six months after setting it, they may lose credibility and thus the power of their “forward guidance”. It is interesting how many commentators state that inflation expectations remain well anchored in the UK stating that this is therefore a reason why the BoE should not even consider raising rates in the near term. However, the BoE’s own survey shows inflation expectations of 3.6% in 12 months’ time, only exceeded in recent years in 2008 (when actual inflation went from 2.5% to over 5%) and in late 2010/2011 (when inflation was between 3 and 5%). Perhaps this just illustrates that this survey is not a very good gauge of where inflation will actually end up moving to and rather is influenced by the current levels, but it is fair to say that inflation expectations remain high despite the fall in inflation levels and certainly high relative to historic inflation expectation levels when rates were considerably higher.
If this high level of UK inflation expectation remains it does not bode well if unemployment continues to fall as employees, who have seen wages stagnant for years and housing costs rapidly increasing, will likely demand pay rises. Monetary policy is supposed to be based on forecasts and address imbalances before they arise and there is a risk that with significant housing cost increases (which do not get captured to any large degree in CPI) we will see wage growth pick up soon. Would the BoE or indeed the government really be able to find some new unconventional monetary or fiscal policy to address the housing market boom without affecting the wider economy? All that has happened so far is the removal of the Funding for Lending Scheme (“FLS”) for mortgage lending but the FLS was not the main cause of house prices rising as rapidly as they have.
One of the biggest concerns the central banks will have when it comes to considering whether to tighten monetary policy is the impact on their currencies. The exchange rate may strengthen on any interest rate increases with a resultant impact on exports and thus growth. They will want to know that other central banks are also withdrawing or about to hike rates to reduce currency fluctuations. It is therefore likely that both the US and UK will start raising rates at roughly the same time. Despite reasonable economic growth expectations and falling unemployment it is likely that, as usual, the central banks will be “behind the curve” so will probably not raise US or UK rate hikes until earlier next year even if warranted sooner. In the meantime 10 year yields are likely to drift higher taking the US to 3.5% and UK to 3.6% by the year end. When they eventually raise rates next year the central banks may well have to play catch up with more aggressive hikes than currently priced in. They risk losing credibility if economic data continues to be strong and they keep backtracking on thresholds set in earlier “forward guidance”.