Carney set to put sterling to the test

Peter Garnham
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The Bank of England’s (BoE) monetary policy committee meeting on Thursday is likely to be overshadowed by an appearance in the UK parliament from Mark Carney, the central bank’s governor elect.

Carney is set to be questioned by the Treasury select committee on Thursday, ahead of the announcement of the Bank’s policy decision.

With the economic outlook broadly unchanged since its last forecasts in November and the minutes of its last policy meeting in January slightly more hawkish than at its previous gathering, the BoE is widely expected to leave interest rates and its asset purchase scheme on hold at 0.5% and £375 billion, respectively.

Carney’s performance will, therefore, be of more importance to sterling watchers, who have seen the pound come under pressure since the start of the year as haven flows from the eurozone reversed and as concerns over the UK’s relationship with Europe undermined the currency.

Indeed, any sign of dovishness from Carney will be seen as an excuse to sell sterling, given the attention gained in the UK of his mention of nominal GDP targeting and interest-rate guidance in a speech last year.
 UK nominal GDP gap - no problem until the financial crisis

However, before sterling bears get too excited, Carney is unlikely to pull the rug from under the pound.

Certainly, he might be asked about GDP targeting, but as Nick Bate, UK economist at Bank of America Merrill Lynch (BAML) notes, there are many difficulties with that approach and the government’s potential support for such a regime has reportedly faded.

Bate points out that had the UK followed a nominal GDP target of 5.5% in the years before the financial crisis, it would have been very closely met, as can be seen in the chart above.

However, in the past few years a 16% gap would have opened up.

“Given the extent to which the financial crisis is estimated to have damaged the equilibrium level of real GDP, only around three percentage points of that shortfall may reflect slack in the real economy, the output gap,” says Bate.

“Thus, to bring nominal GDP back to its target, the Bank of England would have to push up prices by an additional 13% above and beyond those embedded in the nominal GDP target.”

That highlights one of the main caveats to nominal GDP targeting, according to Bate: it treats real GDP and inflation as a package, whereas in reality it is fundamentally important whether nominal GDP growth of 5% reflects real growth of 0% and inflation of 5%, or vice versa.

“Indeed, in the last five-yearly review of its monetary policy framework , in late-2011, the Bank of Canada – with Carney at the helm – chose to stick with a 2% CPI inflation target, judging that it was disciplined but flexible, and remained appropriate no matter the circumstances,” says Bate.

So, unsurprisingly, BAML are not expecting fireworks from Carney on Thursday, let alone any sign of a move to GDP targeting.

That makes sense given that he remains the governor of the Bank of Canada until June 1 and does not start at the BoE until July 1. There would appear to be no need for Carney to be anything but guarded, especially since a lot could change regarding the UK economic outlook over the next six months.

Sterling bears should look elsewhere for the trigger for the next move lower in the currency.