Britain: First Past the Post?
TheFinancialist: Last August, Bank of England Governor Mark Carney made a promise. He and his fellow policymakers wouldn’t consider raising interest rates until the unemployment rate dipped below 7 percent. The threshold sounded far off at the time: officials had forecast that the jobless rate would remain above that level until 2017. But just eight months later, it became clear that their forecasts had been well off the mark. U.K. unemployment had crossed the barrier almost three years ahead of schedule. Last week, the first quarter jobless rate came in at 6.8 percent, the lowest reading in more than five years.
The rapid improvement in the labor market is evidence of a larger story: in the span of just a few years, Britain’s economy has gone from a laggard to a star of the developed world. In 2011, the U.K. economy registered the second most depressed output among developed economies; its contraction of 1.4 percent was second only to Italy’s even more dismal showing. Yet by the end of last year, Britain had performed a remarkable turnaround. Gross domestic product increased 2.7 percent in 2013, a reading that tied Canada for the fastest growth in the developed world. This year, Credit Suisse estimates GDP growth of 3 percent, far above the euro zone’s expected growth of about 1 percent.
If they’d stayed true to their word, the Bank of England should have increased the benchmark rate, which has sat at a record-low 0.5 percent since 2009, already. But that hasn’t happened. Instead, policymakers modified their forward guidance in February when they saw unemployment dropping faster than expected. A rate hike, they said, would no longer be triggered by a breach of the unemployment threshold, but instead by a significant narrowing of the economy’s output gap. The central bank estimates that gap, defined as the difference between an economy’s current output and its maximum potential, is currently between 1 and 1.5 percent of GDP. That’s largely because there’s still slack in the labor market despite the rosier jobless rate. What’s more, the employment picture might not be as good as the data suggests, Carney says, since the U.K. has registered record numbers of part-time and self-employed workers, and there’s been a drop in the number of long-term unemployed. Tame inflation doesn’t give policymakers any sense of urgency about a rate hike either. Consumer prices rose 1.8 percent in April compared with a year earlier, below the bank’s revised target of 2 percent, which is already nearly a percentage point lower than it was a year ago.
Still, investors appear unmoved by the bank’s modified—and less specific—guidance for future policy. Instead, it seems, the market is ignoring the Bank of England’s maneuvering and focusing instead on the positive economic data. The result: the expected timing of the first rate increase should shift gradually, from March 2015 to late 2014. Credit Suisse sees three reasons to think that they might be right. First, say analysts Andrew Garthwaite and Marina Promina, the unemployment rate should keep falling, likely hitting 6 percent by the first quarter of next year. Second, sector wage growth accelerated from 0.6 percent last year to 2.2 percent in April, the highest level since mid-2012. Finally, the output gap is on target to disappear by the second quarter of 2015. “As time has moved on and the recovery has been sustained, the strength of the economy raises the prospect of earlier than expected monetary tightening,” Garthwaite and Promina said in a recent report.
It’s not as if the Bank of England can’t see the writing on the wall either. This month, Carney himself acknowledged that the output gap has narrowed over the past three months, with more and more companies operating near normal levels of capacity Furthermore, the sheer strength of the British pound, which has risen 13.6 percent on the U.S. dollar since last July, is a proof of a more robust economy. And now they’re no longer speaking with one voice. The recently released minutes of the bank’s May meeting show that bank officials are no longer unanimous about the need to maintain current rates, and have begun to voice “a variety of views on the appropriate path of monetary policy.” And there you have it: As it stands, the country’s central bank is the leading candidate to be the first major developed economy to tighten monetary policy since the global financial crisis. It’s the pole position that nobody wanted.
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