Bank of England: This is now a Question of Credibility

- 'Toing' and 'froing' on interest rate guidance has undermined Bank's grip on market guidance

- Bank of England has little choice but to signal an August rate rise

- Risk-reward skewed to the upside for Sterling ahead of May 10 event

© Simon Dawson, Bloomberg, Bank of England

For the Bank of England, May's interest rate policy decision and Inflation Report is not simply about guiding market expectations on the path of future policy, rather it's about the continued credibility of its ability to deliver any worthwhile guidance at all.

The Bank of England's credibility has again taken something of a hit having apparently u-turned on a perceived commitment to raising interest rate rises in May. From a +80% chance assigned by markets just a few weeks back for a May rate rise to be delivered, the prospect of such an outcome is suddenly below 20%.  

One of the more memorable characterisations the Bank of England has earned in the Mark Carney era is that of an "unreliable boyfriend", a moniker created by MP Pat McFadden when questioning the Bank's knack to gear-up market expectations for an interest rate rise, only to ultimately disappoint.

This moniker was created way back in 2014 at a time when the Bank had been warning markets that the first interest rate rise in years was on its way, but never quite delivering on the the threat.

One had to fast-forward to November 2017 for that elusive interest rate rise.

And, in May 2018 here we are again: having established a narrative over recent months that May is when the next interest rate would be most likely, the meeting will in all likelihood pass without a rate hike.

Bank of England Governor Mark Carney warned on April 19 that such a move was not the done-deal markets had assumed. A done-deal that he and his team at Threadneedle Street had meticulously crafted over many months through various communications. 

In 2014 McFadden said that businesses and consumers had been "left not really knowing where they stand" by statements made by the Bank, and the same problem might certainly apply to the present.

There is a real risk that businesses, consumers and markets start discounting the Bank's forward guidance simply based on the observation that it doesn't stand for much.

"What matter for the Bank of England is less the rate decision itself - as the market has more or less completely written off a rate hike now anyway. Instead it is all about its credibility," says Antje Praefcke, an economist at Commerzbank.

"Up to only about three weeks ago everyone had expected a rate step. Central bank governor Mark Carney’s cautious comments and weak economic data have caused the market to execute a complete U-turn within a short space of time. Following this toing and froing it will be difficult for the BoE to explain its future approach to the market in a credible manner," adds Praefcke.

Of course the Bank of England's message has always been that moves are dependent on the data, and the loss of economic momentum in the opening months of 2018 has been greater than the Bank had anticipated.

But, there does now appear to be a fine line between maintaining credibility and running scared when data doesn't go quite as expected with critics arguing the Bank's interest rates are at emergency settings in the midst of a strong and persistent economic growth cycle.

"This month there is a 6-3 vote on The Times Shadow MPC for a rate rise from 0.5% to 0.75%. I Hope the real MPC is listening. We are moving into the 10th year of economic recovery and rates have been at emergency levels for far too long now," says Andrew Sentance, a business economist with PwC and a former member of the Bank of England's Monetary Policy Committee.

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Eyes on August

So, with the Bank's credibility in question, what can the Bank do to maintain a grip on market expectations?

Analysts are increasingly of the opinion that the Bank won't risk deviating from its recent messaging significantly in order to maintain credibility; in short it will maintain the line that interest rates are rising over coming months.

This now makes the August Inflation Report a favoured option for any move on interest rates.

Analyst Jordan Rochester at Nomura is betting on a rise in the Pound based on the view that the Bank will now condition markets for such a move.

"The main reason why we are confident going into the BoE meeting that this view will work is that in September of last year the BoE was faced with a credibility problem of wanting to raise rates reasonably soon but in a market that failed to price for them. So it introduced “coming months” into the statement to spur a steeper market curve. The Bank may again face such a problem if it were to err too much on the dovish side at next week’s Inflation Report, so we expect it to deliver a balanced statement that will keep each MPC meeting live," says Rochester.

Commerzbank's Praefcke says were the Bank to raise interest rates on May 10 its credibility would take a sizeable hit, as this would constitute a significant surprise that would likely trigger notable financial market volatility. Commerzbank are therefore now also expecting the foundations to be laid for an August rate rise.

Strategists appear to also agree that signalling a rate rise in August would offer Sterling support, however there are warnings that the Bank might have learned a lesson in keeping such a tight leash on market expectations.

Nikesh Sawjani, UK Economist with Lloyds Bank Commercial Banking, says the problem facing the Bank is one of presentation, particularly with much of the communication that will cross the newswires on May 10 unlikely to be seen as supportive of a near-term rate hike.

"Downgrades to the Bank’s growth and inflation forecasts would make maintaining a hawkish bias a difficult 'sell'" says Sawjani, adding:

"The MPC is not averse to ‘jawboning’ to bring markets round to their view. In essence, the MPC has options available to it to counter the current less hawkish stance adopted by market practitioners. However, having been instrumental in guiding the markets towards expecting a rate hike sooner rather than later earlier this year, only to now (most likely) disappoint, there may be some aversion to trying to guide the markets too closely at this stage."

The Bank might thus adopt an opaque stance, at least until there is a firm pick-up in the data.

Such an outcome would likely weigh on Sterling, however it appears the risk-reward skew is now to the upside considering the decline in both the Pound and the Bank of England's credibility recent weeks.

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