Credibility Management, Governor Style Nick Keeling

One month ago, the 10-year gilt yield was 0.80%. Today it is 1.12%, having been as high as 1.20%. A good proportion of this sharp rise can be attributed to Bank of England communication on the back of inflation concerns, primarily that of the Governor, Andrew Bailey.

The Governor has been partly or directly responsible for two or three sharp rises in gilt yields over the past month. While at the same time discussing the difficulties facing the UK economy and the fact that monetary policy cannot solve the problems currently driving inflation, he has also strongly implied that a near term rate rise is necessary to limit medium term inflation expectations. The latest iteration of this repeated (and somewhat confusing) message, on 17th October, culminated in investors bringing forward rate hike expectations to November (the next MPC meeting), prompting a significant rise in short gilt yields while long-term yields were broadly flat.

The change in the shape of the yield curve is interesting. The movements at the short end are expected, given that repeated and repeatedly more stringent signals from any central bank chief on the same subject are bound to create strong expectations. However, while we may disagree with the extent of the tightening being priced in (1% by end 2022), it is important for the movement at the back end of the yield curve. The minimal change in longer-term yields, leading to a flatter curve, is investors communicating those earlier rises in short term rates remove the need for further hikes later. This makes sense – tighter monetary policy reduces growth, which in turn reduces inflationary pressure, making monetary stability or even loosening more likely.

This is reflected in our own forecasts for flat to lower longer-term gilt yields, despite the projected rises in Bank Rate.

Of course, the Governor’s perceived message is being strongly supported by market actions because it reflects the problems around supply chains and labour markets that risk generating sustained inflation. The rise in wholesale gas prices is given as a reason why above target inflation is likely to remain with us longer into next year than expected, and it is one of the reasons that the Governor appears to have become more strident about the medium-term risks for inflation.

The other event that coincided with his shift in tone is the end of the furlough scheme. While the official labour market data covering the months following the scheme’s end won’t be available until mid-December, possibly early January 2022, leading data suggests that a rise in unemployment has been largely avoided, perhaps suggesting that the labour market will contain less slack than originally thought. Broad-based wage rises could follow.

How much weight you apply to the importance of household/business inflation expectations in inflation outcomes will determine whether you feel rates need to be increased now to combat possible future inflation. For the Governor, the question is perhaps simpler – expectations don’t matter as long as the Bank’s credibility for fighting inflation is maintained. Credibility anchors expectations.

Investors focused on Bailey’s weekend statement regarding the need to act, but it was a later point he made that made his position clear. He noted that central banks “have to act… [ ] …to underline the credibility of the regime we have” and “to preserve the huge progress we’ve made in terms of credibility of monetary policy regimes”. He felt this was “critically important”.

The argument goes that a central bank’s inflation fighting credibility will automatically anchor expectations. So, expectations management, or rather credibility management, is very much part of the picture, but perhaps not the only driver here.

The MPC is aware that rates are very low, after being cut to emergency levels to combat the pandemic. The last MPC minutes noted that all policymakers believed that post-pandemic stimulus needs to be unwound at some point. MPC members will know from recent history how difficult it is to normalise policy. With growth already easing and likely to slow further into 2022, especially with rising taxes/bills and COVID cases once again picking up, monetary policy is also stuck at levels that make it very difficult to provide further stimulus if necessary.

The Governor’s repetition regarding inflation looks odd because the more he talks about taking action, the more and sooner the market prices in that action. When expectations are so strong, a decision that does not reflect consensus raises concerns about credibility, exactly the situation that the Governor appears so concerned about.

But from one point of view, it makes perfect sense. What do you do, as a central banker, if you feel rates need to increase, but the economic environment may weaken to such an extent in the future that makes this impossible? Talk up expectations to such a point that a near term rate rise becomes the only and accepted course of action. However, we feel that this type of ideological tightening could be a mistake given the developing pressure on household finances, the possible pickup in COVID infections over the winter and the likely disinflationary effect of a resultant downturn in demand. While the MPC may well follow through on expectations and raise rates sooner than we expect, the pressures described above mean it is unlikely to be the start of a substantial tightening cycle. In our view, the market has therefore priced in excessive tightening and our more measured forecasts for both Bank Rate and longer-term yields reflect this.

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