Bank of England v the City: who's right on interest rates?

Carney's argument is that recovery is in too early a stage to cope with rate rises – but the markets think otherwise

It's early days. Mark Carney is still finding his feet as the new governor of the Bank of England. Financial markets get things wrong with stunning regularity.

All this is true, yet the fact remains that the City's response to Threadneedle Street's forward guidance policy has been negative.

The yield on a 10-year government gilt – a good guide to the long-term cost of borrowing – has been on a rising curve ever since Carney advised that interest rates were on hold at least until the unemployment rate came down to 7%. Probably. Sort of. Unless something untoward happened that would force the Bank to act. In which case, action might need to be taken earlier.

Carney's first big policy intervention may go down as a masterstroke if he eventually convinces markets that interest rates really are on hold for the duration.

For now, though, it looks like a classic case of the old saw that there are some things best left unspoken.

Bank of England will make sure that monetary conditions are kept ultra-loose until there is irrefutable evidence that there will be no growth relapse. During Mervyn King's time as governor it was implicit that there would be no tightening of monetary policy for some time to come and that helped keep bond yields and sterling low. Since the implicit commitment was made explicit on 7 August, both the bond market and the foreign exchange market have brought forward the date when they think the Bank's monetary policy committee will push up the official interest rate from its record low of 0.5%.

Why? Because the City has taken a quick squint at the property market, where the interest-only mortgages that were a feature of the previous boom are making a comeback, and come to the conclusion that the UK is in the early stages of a credit bubble.

That, coupled with a slew of upbeat economic data, has convinced dealers that the Bank will need to cool things down long before the 2016 date pencilled in by Threadneedle Street in its recent inflation report.

This leaves Carney in a bit of a spot. The governor's argument is that recovery is in its early stages and would be jeopardised if bond yields continue to rise. That's quite true. The governor's problem is that the City is not listening and the Bank may need to back words with action in order to get the message across. And loosening policy just as the economy is picking up steam would take some explaining.

Article Source : http://www.guardian.co.uk

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