25th April 2018

Rathbones: The unreliable boyfriend

There is a school of thought that says monetary policy has to shock to be effective.

This argument usually harks back to 1979 when Paul Volcker took the reins at the Federal Reserve (Fed) and aggressively raised interest rates against the market’s expectations. Within six months, the US prime lending interest rate had almost doubled to 21.5%. Inflation, running hot at 14% when he took the job, was below 3% three years later. Markets didn’t see it coming and many investors – particularly bondholders – were routed. It was painful, but by getting control of the money supply inflation was tamed.

This is not the perfect strategy! The country suffered two recessions and unemployment ballooned to 10% in the early 1980s. It almost broke the nation. You would rather avoid getting to the point where you have to throw a tenth of your people out of work to restore balance to your money supply.

The lesson from Mr Volcker’s term wasn’t that you have to trip up financiers and speculators to make central banks powerful. The lesson was that central banks have to be credible: markets have to trust them. Throughout the 1970s Fed chairmen talked tough on busting inflation, but when it came to the crunch, they always relented and kept interest rates relatively low. So when Mr Volcker turned up saying he was going to strangle inflation with very high interest rates, markets thought it would be more of the same. People soon realised he was deadly serious; Mr Volcker made the Fed credible again.

Nowadays, central bankers’ interest rate forecasts and market expectations tend to be broadly in synch. This is driven by two things: firstly, central banks are open about their aims for inflation, unemployment and money growth and all sorts of other measures; secondly, the market trusts that the bank will do what it has said it will to get there.

This brings us to Bank of England Governor Mark Carney. Last week, Mr Carney distanced himself from a 25-basis-point increase in UK interest rates in May that he had telegraphed for a few months. Derivative markets had put the probability of this move at 80%, so the gun-shy move sent sterling sharply lower. Mr Carney blamed Brexit talks, weaker economic data and lower-than-expected (but-still-much-higher-than-target) inflation. To be fair, wages and retail sales weren’t the best. And central bankers shouldn’t act just because the market thinks it will. But this is long-running form for Mr Carney.

So when we grumble that he’s back to his “unreliable boyfriend” ways, it’s not because he made an informed decision to change the expected path of interest rates. It’s because the more he backtracks at crunch time, the less credible the BoE becomes. And the more drastic his successor may have to be to win back the market’s respect.

Investment Commentary, Investments