Guidance on BoE forward guidance

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Guidance on BoE forward guidance Azad Zangana, European Economist October 2013 Azad Zangana European Economist Despite the introduction of forward guidance from the Bank of England (BoE), markets are

We examine the likelihood of this occurring and conclude that it would require an unreasonably bearish view on productivity growth.

At his debut Inflation Report meeting, Governor Mark Carney introduced forward guidance on BoE policy.

1 Guidance on BoE forward guidance Azad Zangana, European Economist October 2013 Azad Zangana European Economist Despite the introduction of forward guidance from the Bank of England (BoE), markets are pricing in a rise in policy interest rates by the end of next year. Markets appear to be more bullish on the prospects for unemployment falling faster than the Bank. We examine the likelihood of this occurring and conclude that it would require an unreasonably bearish view on productivity growth. Gilts may therefore look attractive, while the pound appears vulnerable to a correction. The markets don t believe you! At his debut Inflation Report meeting, Governor Mark Carney introduced forward guidance on BoE policy. Carney announced that the Monetary Policy Committee (MPC) would not consider raising the policy interest rate, and the stock of gilt holdings (acquired through quantitative easing) would not be reduced, before the rate of unemployment falls to a threshold of 7% (currently at 7.7%). The governor stressed that the 7% threshold is not a target, but a reference point at which the MPC would reconsider the appropriateness of interest rates. Three knock-out conditions were also attached to the guidance in order to re-assure the public that inflation and the stability of the financial system were also being considered by the Bank. The BoE had expected its forward guidance to lower market interest rates considerably. Confidence in the policy was such that in the August Inflation Report, the Bank did not publish a growth and inflation forecast based on market interest rates, arguing that its forecast using constant interest rates (at 0.5%) should become the same once forward guidance had fed into market expectations. Interestingly, the opposite has happened. Investors have raised their expectations of the level of the policy interest rate since the announcement. At the start of the year, the government s funding for lending was helping to increase market liquidity and drive down mortgage and wholesale interest rates. Indeed, market expectations of rates fell further through June and July when it became clear that forward guidance was on the way, but by close on the day of the announcement, markets had begun to price in one 25 basis points rise by the end of 2014, and a further two by the end of The latest market expectations have risen further with investors now expecting a full percentage point rise by the end of 2015 and over 1.75% by the end of 2016 (see chart 1 on next page).

2 Charts 1 & 2: Markets do not believe Carney s forward guidance Short Sterling contract yield minus 3-month LIBOR Index (100 = 01/08/13) 2.00% 108 Date of yield snapshot % -1 year % -6 months 105 Aug '13 IR 1.25% Latest % % 0.50% 0.25% 0.00% 98 Dec '13 Dec '14 Dec '15 Dec '16 Aug Sep Oct Contract maturity EUR USD JPY Source: Thomson Datastream, Schroders. October 7, Performance shown is past performance. Past performance is not a guide to future performance. The value of investment can go down as well as up and is not guaranteed. Admittedly, the Federal Reserve s quantitative easing tapering shenanigans have helped swing UK rate expectations, but the recent strong rise of sterling against the US dollar, the euro and yen since the start of August show that there is more at play than the impact of US treasury yields (see chart 2 above). 7.0 is the new 2.0 In our view, the key factor driving the market to price in earlier interest rate rises than indicated by the BoE is the Bank s 7% unemployment rate threshold. Whilst the Bank has been at pains to stress that the 7% is neither a trigger nor a target, it appears that the market is anticipating a faster recovery in the labour market, and hence pricing in higher interest rates. The BoE s August Inflation Report included a forecast of the unemployment rate, which predicts the threshold to be intact at the end of the forecast horizon of mid-2016 (see chart 3). Indeed, the BoE sees the cumulative probability of hitting the 7% threshold by the middle of 2016 to be just over 50%. Chart 3: BoE unemployment rate forecast based on constant interest rates 8.5% GBP appreciation 60% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 50% 40% 30% 20% 10% 5.0% Cumulative probability that U/E rate falls below 7% Unemployment rate, lhs BoE forecast of U/E rate Source: Bank of England August 2013 Inflation Report. Could the unemployment rate fall faster than the Bank expects? Are markets correct to assume that the recent strength in private business surveys will force the BoE to reconsider interest rates sooner? Before we can consider these questions, we have to take into account the UK s labor market performance in recent years. Despite close to no GDP 0% 2

3 growth, the economy has added 1.1 million jobs since June 20111, helping the unemployment rate to fall slowly. As a result, productivity measured by output per worker, per job, or per hour worked, has fallen sharply. In fact, the UK s productivity performance is tied worst with Italy amongst the G7 since 2007 (chart 4). Chart 4: G7 comparison of productivity (output per hour) Index (100 = 2007) US Jap Can Fra Ger UK Ita Source: Office for National Statistics, Schroders. September 27, Regions shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. There are a number of possible reasons behind the UK s poor productivity performance. The cull of financial services (highly productive sector); zombie companies being kept afloat with low interest rates; labor hording by companies; and the wide use of temporary workers on zero hour contracts may all be contributing. The key question for the unemployment rate is: will productivity recover, or will it continue to perform poorly? The BoE believes productivity will improve and that companies will be able to increase output, but will not need to hire many more people. The bank believes that companies will invest in capital, which with their existing workforce, can boost output. We believe that there has been a permanent loss in productivity growth, although we too expect some recovery in productivity in the near term, and we are not alone. The HM Treasury survey of independent forecasters shows that only one of the 22 institutions that answered expects unemployment to reach 7% at the end of The consensus amongst forecasters is for the unemployment rate to fall to 7.4%, with our own forecast at 7.5% (see chart 5). 1 Based on the Workforce Jobs survey to June Source: ONS Labour Market Statistics, September

4 N DCM ING EP RBS Sb SG EIU GI BoA HSBC CBZ GS S BCC BEF CBI CEBR BCC NIESR CG LS Talking Point Guidance on BoE forward guidance Chart 5: Comparison of independent forecasts of the unemployment rate 8.4 LFS Unemployment rate forecast (2014 Q4, %) 8.2 Consensus From left to right: Nomura, Daiwa Capital Markets, ING Financial Markets, Economic Perspectives, Royal Bank of Scotland, Scotiabank, Societe Generale, Economist Intelligence Unit, HIS Global Insight, Bank of America/Merrill Lynch, HSBC, Commerzbank, Goldman Sachs, Schroders, British Chambers of Commerce, Beacon Economic Forecasting, CBI, CEBR, Barclays Capital, NIESR, CitiGroup, Lombard Street Research. Source: HM Treasury September 2013 Forecasts for the UK economy: A comparison of independent forecasts. The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Scenario analysis To illustrate the importance of the assumptions made on productivity in producing unemployment forecasts, we have generated three scenarios where we allow productivity growth to vary to different degrees, and examine the results on unemployment. This follows Okun s Law (1962) which describes the strong negative relationship between GDP growth and unemployment. However for this analysis, we have focused on employment growth, and made a number of assumptions to simplify the models. Specifically, we have assumed no change in the current growth rate of the working population (0.7% per annum); average hours worked unchanged at 32 hours per week; inactivity rate unchanged at 36.5%. Finally, we have assumed a single path of GDP growth based on our own forecast (1.4% for 2013; 2.1% for 2014; 1.9% for 2015; 2.2% for 2016 and 2.4% 2017). We acknowledge that a number of combinations of GDP and productivity growth are possible, but as the Schroders GDP forecast is very close to the current consensus, this should be close to the market s view. Later in this paper, we expand the analysis to allow for different combinations of growth and productivity. The three scenarios are: 1. Productivity recovery, which assumes the relationship between employment growth and GDP growth resumes in lock-step over the coming year. 2. The Schroders forecast, which assumes a partial recovery in productivity, but lower trend growth further out. 3. Market view, which attempts to back out the productivity growth profile needed to bring unemployment down to 7% by the end of 2014, which is consistent with the first interest rate hike currently priced by the market. The rate of employment is then held constant for the remainder of the modelling period. Chart 6 shows the historical relationship between employment growth and real GDP growth, along with the three scenarios as described above. The relationship between the two has always been very close, with GDP leading employment growth by approximately one to two quarters. Therefore, the recent divergence between the two is very unusual. 4

5 Chart 6: Scenario analysis of employment growth 8% 6% 4% 2% 0% 2% 1% 0% -2% -4% -6% -8% Projected GDP growth, lhs Employment growth, rhs Empl. growth: "productivity recovery", rhs Empl. growth: "Schroders forecast", rhs Emp. growth: "market view", rhs Source: Thomson Datastream, ONS. Schroders calculation. October 7, The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. -1% -2% -3% Chart illustrates what the above employment growth assumptions imply for the level of productivity growth. Over the modeled forward looking period, the productivity recovery scenario averages productivity growth of 1.6% per annum, which is still considerably lower than pre-financial crisis average of 2.5%. The Schroders forecast has 1.2% growth per annum, but the market view scenario only has average productivity growth of 0.8% per annum. Chart 7: Scenario analysis of productivity recovery (output per hour) Index (100 = Q1 2007) Projected Productivity growth Productivity recovery Schroders forecast Market view Source: Thomson Datastream, ONS. Schroders calculation. October 7, The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Finally, chart 8 demonstrates the vast difference in outcomes for the unemployment rate given the different assumptions on productivity growth. In the productivity recovery scenario, the unemployment rate actually rises from here, and does not turn decisively. The Schroders forecast assumes the BoE s 7% threshold is reached in 2016, while the market view scenario was based on unemployment hitting 7% at the end of 2014, but with the employment growth assumption held constant, results in the unemployment rate falling below 5% by

6 Chart 8: Scenario analysis the unemployment rate 10% Projected 9% Unemployment rate Productivity recovery Schroders forecast 8% Market view 7% 6% 5% 4% Source: Thomson Datastream, ONS. Schroders calculation. October 7, The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. It is worth mentioning that there are a number of risks to this analysis, and the simplifications made. The first being the impact of an aging population, which is likely to raise inactivity rates, and reduce the unemployment rate faster. Recently, inactivity rates have been falling, although this is probably a cyclical swing caused by previously discouraged workers coming back into the labor market. However at the same time, underemployment is very high, with many being forced to take on zero-hour contracts, and/or become self-employed. Similarly, the number of average hours worked has been higher and could rise from here as demand increases. This could boost GDP, keep productivity (per hour) relatively unchanged and not reduce the unemployment rate. Finally, there are downside risks from the growth in the working population (16+). Growth in immigration had eased since 2007 due to the financial crisis, but as the economy recovers, more migrants could be attracted once again. This would increase the unemployment rate assuming not all are successful in finding work, and some locals are displaced. Conclusions Comparing the three scenarios, the first productivity recovery scenario would be the default scenario for most economists, and is indeed the reason why most have been caught out by the strength of the labour market over the past two years. However, it is clear that there has been a permanent hit to potential growth, and we should not expect a return to such strong productivity growth numbers in the near term (at least, not while austerity is dominating government policy). At the other extreme, the scenario modeling the market view appears too pessimistic. It is difficult to imagine the level of output per hour worked growing at such a slow pace, that it does not surpass its previous peak before the end of We mentioned earlier that we assumed a single path of GDP growth, but that many combinations of GDP and employment and productivity growth can be used when simulating unemployment rate outcomes. Table 1 is a matrix that shows our estimate of the unemployment rate in the fourth quarter of 2015, given the various GDP growth and productivity growth assumptions. Table 1 highlights the need for strong GDP growth in order to bring down the unemployment rate, but in addition, productivity growth cannot be too strong. Indeed, if productivity growth was to return back to its long-run average of 2.5% per annum, then the UK would need to see annual GDP growth averaging more than 3.5% to hit the 7% unemployment rate threshold. 6

7 Average annual productivity growth (% GDP per hour worked) Talking Point Guidance on BoE forward guidance Table 1: Sensitivity analysis of the unemployment rate to changes in GDP and productivity (per hour) Unemployment rate, Q (%) Average annual GDP growth (%) Market Schroders BoE Source: Schroders calculation. October The opinions stated include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. We have marked our central view on the above matrix with the navy blue box labelled Schroders, while the grey box shows our estimate of the market s view. Finally, we have calculated the implied productivity growth rate used in the BoE s forecast, and taken the modal GDP forecast, and marked it using the orange box. While the BoE has a more positive GDP growth forecast than our central scenario, it also has a stronger recovery in productivity growth, which leads to very similar views for the unemployment rate. However, the market s view leads to a much lower unemployment rate, as shown previously. Given the above analysis, we disagree with the current market pricing on interest rates, and expect the BoE to keep its policy rate on hold until at least 2016, and possibly even into We struggle to make a case for the unemployment rate falling much faster than our current forecast. In terms of investment implications, our conclusions suggest that the front end of the sterling curve is attractive, while GBP may be looking vulnerable. In fact, GBP may have already started a more meaningful downward correction in recent days. 7

8 Important Information: The views and opinions contained herein are those of Azad Zangana, European Economist, and do not necessarily represent Schroder Investment Management North America Inc. s house views. These views are subject to change. This newsletter is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. Past performance is no guarantee of future results. Sectors/regions mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties. Schroders has expressed its own views and opinions in this document and these may change. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroder Investment Management North America Inc. ( SIMNA Inc. ) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the Schroder Funds.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. Further information about Schroders can be found at Further information on FINRA can be found at Further information on SIPC can be found at Schroder Fund Advisors LLC, Member FINRA, SIPC 875 Third Avenue, New York, NY

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