Goldilocks and the Three Knockouts.

21st January 2014

The era of low interest rates is shaping up to keep going well into 2015 and potentially beyond.

In response to the credit crunch, the Bank of England’s (BoE) Monetary Policy Committee (MPC) cut interest rates sharply: between September 2008 and March 2009 interest rates were cut 6 times from 5% to 0.5%, where it has remained.

Given that interest rates can’t fall much lower as they are ‘zero lower bound’ (economies can only operate with positive interest rates because negative interest rates would result in everyone starting to hold physical cash), the BoE has been forced to look at unconventional monetary policies to help stimulate economy.

To date this has focused on purchases of assets (the vast majority of which have been government gilts) in a process known as ‘quantitative easing’ (QE). In total the BoE has purchased £375bn of assets. Given that the government’s net public sector debt is about £1,200bn, it means that the BoE owns nearly 30% of public sector debt!

With the UK economy now growing faster than everyone thought possible at the start of the year, when newspaper headlines talked of a ‘triple-dip’ recession, the BoE needs to make sure that this emerging economic recovery continues to strengthen (although it is very positive that the economy is finally growing, this recovery has been much weaker and slower compared with previous recoveries and current recoveries in many other advanced economies).

To do this the new Governor of the Bank of England, Mark Carney, introduced the UK to another important unconventional monetary policy, called ‘forward guidance’.

The objective of forward guidance is to influence expectations about how long the MPC’s current highly accommodative stance of low interest rates will be maintained as economic conditions improve: by lowering expectations of the future path of interest rates it is hoped that business and consumer confidence is increased. It is this confidence that will drive the recovery, especially as 70% of loans to households and more than 50% of loans to businesses are linked to the BoE base interest rate.

Mark Carney announced that at the MPC meeting on 1 August it was agreed that interest rates would not be increased from the current level of 0.5% until the unemployment rate fell below 7%.

Given that the UK’s unemployment rate is currently 7.6%, it means that approximately 750,000 new jobs will need to be created before interest rates are reassessed, which according to MPC projections, could take 2 years or more (i.e. interest rates could remain unchanged until the end of 2015). In addition, once unemployment falls to 7%, it is not necessarily the catalyst for increasing interest rates (Mark Carney has stressed that 7% is not the trigger for raising interest rates, it is just a staging post to assess the economy).

Why 7% unemployment? The BoE has probably chosen to focus on the unemployment rate as it is not a volatile measure and relates directly to the amount of spare capacity that is in the economy.

Chart 1shows UK unemployment over the past 2 decades (a period of good economic growth and one in where the BoE had to regularly act to keep inflation under control). It also shows that interest rates have rarely been increased when unemployment has been above 7% – so the MPC simply appears to be making this connection explicit.

Chart 1

When Harold Macmillan was asked about the most important factors driving his decisions as Prime Minister, he is attributed as replying, “Events, dear boy, events” (I say attributed, because according to my Google searches, he may never have actually said these words). However, whether he said the words or not, the quote makes the point perfectly: the unexpected can ruin the best laid plans.

Consequently, the BoE has not promised unconditionally to keep interest rates at 0.5% until unemployment falls below 7%. The MPC has set 3 events or ‘knockouts’ where the 7% unemployment rate would cease to hold: the most important one is if CPI (the official measure of inflation), in the MPC’s opinion, is likely to be above 2.5% in 1.5 to 2 years’ time (is this a subtle change to the official 2% inflation target?). The other 2 knockouts are triggered if the medium-term inflation expectations become unanchored or if the Financial Policy Committee (FPC) believes that there is a threat to financial stability.

Chart 2

Chart 2 shows that the UK’s ‘output gap’. The output gap is the difference between potential Gross Domestic Product (GPD) if the credit crunch had never happened and what it actually is now: UK GDP is still more than 2.5% below its actual pre-crisis level and about 20% below the level that it would be at had it continued to grow at its average pre-crisis rate. With this margin of slack in the economy, inflation isn’t likely to be a problem (see chart 3).

Chart 3

This is because consumers aren’t spending and demanding more goods – it has been the complete opposite: it is non-discretionary items such as food, fuel & energy, university tuition fees and VAT increases that have caused our inflation over the past couple of years.

Discretionary spending inflation hasn’t been a problem as real incomes have been squeezed by stagnating wages.

Consequently, I can’t see any of these 3 knockouts coming into play before the 7% unemployment threshold is reached (especially as the first knockout can be whatever forecast inflation that the MPC likes, while the other 2 are subjective).

From an investment perspective all this adds up to a Goldilocks scenario (i.e. cold enough for the BoE to maintain their stimulus with low interest rates, but warm enough for the economy and company profitability to grow). A potentially promising combination for equity markets!