UK: Carney Disappoints and Boosts Pound

UK: Carney Disappoints and Boosts Pound

After an eventful year of Olympic games and Diamond Jubilee celebrations, the Bank of England (BOE) decided to adopt a policy of forward guidance. Committed to keeping interest rates on hold until the unemployment rate falls from the current rate of 7.8% to at least 7%. The new BOE governor, Mark Carney, didn’t touch the current level of asset-purchase (which will stay at 375 billion pounds). However, he’s trying to improve communications with the market by adopting forward guidance and tying current monetary policy to known economic variable–mirroring what the U.S Federal Reserve does. The move was appreciated by George Osborne, Chancellor of Exchequer, but was not enough to satisfy the quantitive easing (QE) addicted investors, which quickly tarted selling the FTSE 100 and closed short pound positions. The pound rose 300 pips against the dollar in just a few hours and is now trading neat 1.5560 after hitting an intraday low of 1.5205.

Carney’s move is aimed at adding transparency to monetary policy and bettering investor’s expectations in an attempt to avoid a premature interest rate rise led by wrong assertions. This resulted in a quick appreciation of the pound because investors were expecting Carney to expand the asset purchase program by at least 25 billion pounds.

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An Unfavorable Context To Expand QE

The British economy has been in a stagnant state for the last two years and has just avoided a triple dip as GDP inverted the previous quarter (a 0.3% loss) with a 0.3% gain in the first quarter of 2013. A depressed consumer along with a delayed European economy isn’t helping the British pick up in activity, and many have been pushing for an expansion of the QE program to boost financial assets. Eventually, this expansion would induce an accelerated economic recovery. However, unlike the situation in the U.S, the context in which Carney acts is much more unfavorable to push for further easing. First of all, the BOE is governed by a single mandate towards price stability, so levels of GDP growth and unemployment rate should be regarded when taking decisions, but never pari passu. Second, inflation in the UK has been above the BOE target during the last four years, meaning there;s not much flexibility to expand monetary policy.

So, Why Are Investors Buying The Pound?

If the exposed isn’t enough to explain why investors were so disappointed with Carney’s decisions, then his economic projection could help understand it. Carney significantly revised projections for GDP growth in 2014 from 1.9% to 2.7%. With an expected growth of 2.7% and an inflation rate at 2.9%, there’s absolutely no reason for the BOE to further ease its policy. In doing that, the central bank would be acting outside its mandate. At the same time, such an upgrade on GDP growth also could mean an upgrade on the expected pave of employment creation which means reaching the 7% threshold much earlier than expected. In our view, this could very well be possible by 2014. With that, the BOE benchmark rate (currently at a record low of 0.5%) could start riding in the first quarter of 2015. However, if the inflation rate rises above the current levels, the central bank may even need to consider an earlier start.

The change in expectations will pressure the pound to rise. Yesterday’s move most certainly put an end on QE in the UK, and while there’s uncertainty about what will happen in the U.S, the pound will most likely recover most of the loss it recorded since the start of 2013.

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